Know your risks before investing in mutual funds

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For investors, risk is inevitable. In the current times, very few investments are considered to be risk-free, but they offer low returns. Risk and returns are highly correlated.  Investments such as mutual funds that offer higher returns, also carries various risks.

The underlying reason mutual fund investments are risky is that they invest in a variety of investment products, including debt, stock, and corporate bonds. Further, the prices of these investment instruments change in reaction to a variety of external events, and investors may suffer a loss. This is primarily due to the decline in the net asset value (NAV) of these investments. However, mutual fund investors can maximize the investment tool’s risk-reward profile by understanding the risks associated with mutual funds. That said, the best thing an investor can do to mitigate mutual fund risks is to educate themselves about them and adopt risk management techniques. Let’s take a look at different kind of risks, that impacts the mutual fund investors:

Market-related risk

We have all seen one-liner that mutual fund houses advertise by mentioning that mutual funds are subject to market risk; please read your offer document carefully before investing. To simply put, market risk is a risk that any investment may incur losses due to the market’s poor performance.

Numerous things influence the market.  Natural disasters, inflation, recession, political upheaval, and interest rate fluctuations are just a few examples. Market risk is sometimes referred to as systematic risk. Diversifying an individual’s portfolio will not help in these situations. An investor can only wait for events to unfold and take expert advice on whether to stay or redeem the mutual fund units.

Portfolio concentration risk

Concentration generally refers to focus on one particular thing. Concentrating a significant portion of a person’s investment in a single scheme is never a wise idea. Profits will be enormous if you are fortunate, but losses will be severe at times. The most effective method to mitigate this risk is to diversify your mutual fund holdings.

Concentrating your efforts and investments in a single area is likewise risky—the greater the diversification of the portfolio, the lower the risk. For example, suppose you only concentrate on investing 100% in sectoral funds. There is a significant risk in that case, as sectoral funds by nature are higher in risk as they invest in a particular sector.

Interest rate risk

Interest rates in a market represent credit availability, and the country’s economic health influences them. This typically impacts fixed-income mutual funds and other fixed-income investments, such as debt funds. Bonds become less advantageous when interest rates rise and their prices fall. Likewise, the converse is true. While debt funds are typically severely impacted by interest rate increases, they may also result in a short-term drop in the value of equity-oriented funds.

Liquidity risk

Liquidity risk is the inability to redeem an investment without incurring a loss in value. Additionally, it might occur when a seller is unable to sell the security. The lock-in period of mutual funds, such as equity-linked saving schemes (ELSS), may result in liquidity risk. During the lock-in time, nothing can be done. Additionally, exchange-traded funds (ETFs) may face liquidity risk.

As you may be aware, ETFs, like stocks, can be bought and traded on stock exchanges. Occasionally, because of a lack of purchasers in the market, you may be unable to redeem your investments at the time of greatest need. The most effective strategy to avoid this is to maintain a broad portfolio and choose funds with care.

Credit risk

Credit risk refers to the possibility that the scheme’s issuer will be unable to pay the interest pledged. Typically, rating agencies grade investment firms based on these factors. Thus, an individual will constantly notice that a company with a good rating would charge less, and vice versa.

Credit risk is also a concern for mutual funds, particularly debt funds. The fund manager of debt funds is required to invest exclusively in investment-grade assets. However, the fund manager may include lesser credit-rated securities to gain better returns. This would enhance the portfolio’s credit risk. Consider the credit ratings of the debt fund’s portfolio composition before investing.