‘Mutual fund investments are subject to market risk’, this famous line is the centre for many memes and reels and you would definitely find one in your daily social media feeds. This one line deterred many investors from mutual fund investments for many years before mutual funds were demystified and are now a staple in any investment portfolio. But does that mean that these risks should be ignored? Of course not. The key to any successful investment is knowing the risks first and then taking the plunge. So here are the risks involved in mutual fund investments. Know all about them and then make your informed investment decisions.
Why is risk evaluation important in mutual fund investment?
Let us first begin with the primary question, which is the need for risk evaluation in mutual funds. Risk evaluation is crucial in mutual fund investment for investors because it helps you make informed decisions and protect your financial goals.
India’s mutual fund market offers a wide range of funds with varying risk profiles, and understanding the level of risk associated with each fund is essential. By assessing risk, you can align your investments with your risk tolerance and financial objectives. This evaluation also aids in diversifying your portfolio effectively, ensuring you don’t put all your money into high-risk funds, which could lead to substantial losses. Ultimately, it allows you to strike a balance between potential returns and the level of risk you are comfortable with, thereby optimizing your chances of achieving your investment goals.
What are the types of risks in mutual fund investments?
The risks in mutual funds can be broadly classified into two categories namely, systematic risk and unsystematic risk. Systematic risk is the portion of risk that is inherent in the overall financial market and affects all investments to some degree. It cannot be eliminated through diversification because it’s tied to factors that influence the entire market. These risks are further broken down and explained hereunder.
Market risk, also known as equity risk when dealing with stocks, is the most fundamental risk in investing. It is the risk of losing money due to fluctuations in the financial markets. Mutual funds investing in equities are particularly susceptible to this risk. Factors like economic conditions, global events, interest rates, and investor sentiment can cause the overall market to rise or fall. When the market falls, the value of your mutual fund units can decline, potentially leading to losses.
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Interest rate risk
Interest rate risk is a concern primarily for debt mutual funds. It relates to the sensitivity of bond prices to changes in interest rates. When interest rates rise, the prices of existing bonds in a debt fund’s portfolio tend to fall because newly issued bonds offer higher yields. This can lead to a decline in the Net Asset Value (NAV) of the fund. Conversely, falling interest rates can boost bond prices and increase the NAV.
Credit risk, also known as default risk, pertains to the possibility that the issuer of the bonds held by a debt mutual fund may fail to make interest or principal payments. Lower-rated or riskier bonds offer higher yields but come with a greater chance of default. Funds with a higher allocation to lower-rated bonds have higher credit risk, which can result in losses if issuers default.
Reinvestment risk impacts debt mutual funds when the income generated from maturing bonds or coupon payments is reinvested at a lower interest rate than the original investment. For example, if a bond in the fund’s portfolio matures and the prevailing interest rates have declined since the bond’s purchase, the fund will have to reinvest the principal at a lower rate. This can result in lower future returns for the fund, as the new investments generate less income. Reinvestment risk is especially pertinent during periods of declining interest rates.
Inflation risk is the concern that the returns from your mutual fund investments may not keep pace with inflation. When the rate of inflation exceeds the returns earned from your investments, your purchasing power diminishes over time. Essentially, your money buys less, and the real value of your investments decreases. Investors in funds that don’t provide returns above the inflation rate may find it challenging to maintain the same standard of living in the future.
Sectoral risk is associated with investing in mutual funds that concentrate on specific sectors or industries, such as technology, healthcare, or finance. These funds are heavily influenced by developments within the chosen sector. For instance, a technology-focused fund’s performance will depend on the growth, innovation, and regulatory landscape within the technology sector. Sectoral risks make these funds susceptible to sector-specific challenges, such as changes in government policies, shifts in consumer preferences, or competitive pressures.
Political and regulatory risk
Political and regulatory risk arises from changes in government policies, tax laws, or economic conditions. In emerging markets like India, where regulatory changes can be frequent, this risk can significantly impact mutual fund performance. For instance, alterations in taxation on capital gains can affect the returns from equity mutual funds. Similarly, shifts in government policies or regulations can impact various aspects of the market, affecting different types of funds.
Economic risk encompasses broader economic factors like GDP growth, inflation, and overall market sentiment. Economic downturns, recessions, or financial crises can lead to reduced returns in various types of mutual funds. Economic risks can influence the performance of the underlying assets within the fund, affecting both equity and debt securities.
Management risk is specific to actively managed mutual funds. It refers to the risk that the fund manager’s decisions and investment strategy may not perform as expected. Poor management decisions, misjudgments, or unsuccessful strategies can lead to underperformance compared to market benchmarks. Investors in actively managed funds rely on the skill and expertise of the fund manager, making management risk an important consideration when choosing such funds.
Concentration risk typically involves a significant allocation of one’s investments into a single scheme or sector. While this strategy can yield substantial profits when fortunate, it also exposes investors to pronounced losses during unfavorable times. To mitigate this risk, it is advisable to diversify your investment portfolio. Avoiding heavy concentration in one particular scheme or sector is crucial, as a more diverse portfolio tends to reduce overall risk.
How to reduce risk in mutual fund investment?
Diversification is key to countering the risk from mutual fund investments. Spread your investments across various mutual funds with different asset classes like equity, debt, and hybrid funds. This will help reduce the impact of poor performance in one fund on your overall portfolio. Additionally, consider your investment horizon and risk tolerance when choosing funds.
We often invest in mutual funds and forget about taking stock of our investments. This is a dangerous practice as some of the funds may not stay aligned with your goals and risk-return expectations with the fluctuations in the stock markets. Therefore, regular review and rebalancing of the portfolio to maintain the desired asset allocation is equally important. You need to stay informed about economic and market developments and avoid making any impulsive decisions based on short-term fluctuations. Lastly, one of the best and easiest tips is to consider consulting a financial advisor to help you make informed investment decisions tailored to your specific financial goals and risk tolerance.
Mutual fund risks are an inevitable part of the investment that cannot be completely negated. However, to meet the financial goals in a successful and timely manner, it is important to align them with your risk-return expectations. Investors can also get help from professional fund managers to understand the risk profile of different types of mutual funds and carefully shape their investment portfolios.