Mutual Fund Risk - Know the Types of Risks Involved
Mutual funds are one of the most popular securities to invest in currently. Diversified, convenient and professionally managed, mutual funds offer attractive returns. However, these investments come with their own risks.
Although mutual funds are considered to be a relatively safe investment tool, their performance depends on the prevailing market variations. Like any other scheme, investing in mutual funds involves a certain amount of risk. The risk involved in mutual funds depends on a lot of factors like the government's economic policy, existing economic conditions in the country, the gap between demand and supply, etc. affect the value of these instruments. To maximise your return on investment, you must choose your mutual fund wisely.
Can Mutual Funds be Considered Safe?
Types of Risk In Mutual Funds:
We can classify all risks in mutual funds broadly into two categories:
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Systematic Risks
These are the types of risks that one cannot control. They become unavoidable. For example, any regulation that affects many assets falls under the category of systematic risks.
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Unsystematic Risks
Also known as specific risks, these risks affect a small class or a group of mutual funds. For example, any accident or criminal inquiry on a firm can decrease the value of its shares.
Additional Risks in Mutual Funds
Apart from these broad categories, we can further classify the risk in mutual fund investment into the following types:
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Risk of Increase in the Interest Rates:
Interest rates in a market reflect the availability of credit, and the economic state of the country influences it. This usually affects the fixed-income mutual funds and investments such as debt funds. As interest rates go up, investment in bonds seems less profitable than other investment options, and their prices go down. The reverse is also true.
While it is usually debt funds that may be impacted negatively with the increase in interest rate; it may also lead to a decline in the value of equity-oriented funds in the short-run.
Pro Tip: Keep a longer time-frame while investing in mutual funds to ensure the negative impacts of an increase in interest rates are balanced out.
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Market Risks:
In simpler terms, it is the risk you take by investing in the stock market. Since every market follows its cycle and trends, market risk comes under the systematic category. In market risk, your investment may suffer due to unfavourable market conditions.
Pro Tip:To circumvent the market risks, you can build a well-diversified portfolio that has a balanced exposure to equity and debt investments. Moreover, you must invest in mutual funds for a longer time to ensure the ups and downs in the market are averaged out, and you get desired returns.
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Risk of Inflation Crossing Returns on Investments:
Inflation Risk is the risk associated with the reduction in purchasing power of the investor due to rising prices of commodities. As an investor, you would want the return on the investment to be more than the prevailing inflation rate. For example, if the money invested in mutual funds gets you a 7% return, and the inflation rises by 4% within the same period, your net purchasing power increases by 3% only.
Pro Tip: While selecting mutual funds, make sure the schemes you choose have the potential to give you inflation-beating returns. Generally, equity-oriented mutual funds are considered to have a high-return potential that can beat inflation. However, they also carry a certain amount of risk with them.
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Risk of Lower Liquidity:
Liquidity risk is the risk associated with lowering liquidity in the market. This could happen due to many reasons, such as interest rates increase, changes in currency value, etc. In financial sectors, liquidity refers to the ability to sell the asset quickly to arrange funds.
For instance, investment instruments with lock-in periods like fixed deposits or ELSS - based mutual funds pose liquidity risk. Similarly, it may be challenging to sell Exchange Traded Funds (ETFs) during a liquidity crisis without suffering losses. While it affects these funds directly, it impacts all types of mutual funds negatively as the fund manager finds it hard to sell the equities in the stock exchange without suffering some losses.
Pro Tip: Ensuring that you can remain invested for long can help you overcome this risk. Moreover, do consider including a few short-term and medium-term debt funds in your portfolio to avoid the temporary problem of liquidity.
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Credit Risk:
Credit Risk is the risk associated with a bond defaulting on the grounds of non-payment by the lender. Thus, this impacts all mutual funds that may have exposure to bonds. Credible agencies give ratings to bonds based on the risk associated with a bond. Generally, the PSU bonds or AAA bonds are the safest and possess the least credit risk.
Pro Tip: Look at the credit rating of a debt fund before investing. Moreover, diversify your portfolio to safeguard the interest.
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Concentration Risk:
Concentration risk arises when you focus all your investment on a particular mutual fund or sector. If the sector defaults due to government policy or bankruptcy, your entire investment is impacted negatively.
Pro Tip: All financial experts emphasise diversifying your portfolio by investing in different sectors to balance the risk.
Be Aware of the Risk and Build a Diversified Portfolio
Every financial instrument comes with a certain level of risk incorporated within. The same applies to investing in mutual funds. The points above give you an idea of some of the mutual fund’s risks and how you can mitigate them. Make sure you select the mutual funds wisely. Most importantly, build a diversified portfolio that not only helps you reach your financial goal but also safeguards you from all the risks.