Article Content
- Are Investments in Mutual Funds Risky?
- Risk Types in Mutual Funds
- Risk Mitigation Techniques
Investing in any asset is primarily done for financial gain. Returns vary depending on the type of investment. No investment is risk-free, either. The risks associated with investing vary. Investments in mutual funds are not risk-free either. Mutual funds have certain inherent risks even if they are diverse investing solutions. This article goes into great length on the many risks associated with mutual funds as well as several risk-reduction strategies.
Are Investments in Mutual Funds Risky?
Mutual funds invest in a variety of financial assets, including government securities, commodities, bonds, and stocks. As a result, the investments are subject to various risks. Market, liquidity, volatility, concentration, etc. risks are all present in the equity element of the programme. The debt element also carries risks related to interest rates, inflation, credit, etc. Risk is therefore inherent in all financial instruments and asset classes.
Every mutual fund must use a Risk-o-meter to define the scheme's degree of risk in accordance with SEBI regulations. The risk levels of equity mutual funds, credit funds, and hybrid funds are moderate to high. Debt mutual funds, however, are low-risk investments.
Investment risks can be roughly divided into the following categories:
Systematic Risk
Systematic risk is a sort of risk that impacts most assets in mutual funds and is out of your control. For instance, some statements or rules made by the government may affect your investments. These regulatory choices are systemic risks since you have no influence over them.
Unsystematic Risk
A particular asset is particularly affected by unsystematic or unique risk. A company-specific example might be if a fire breaks out without warning or if employees go on strike. The stock values of the corporation would be impacted as a result.
Risk Types in Mutual Funds
The many categories of risk in mutual funds are as follows:
1. Risk of Market Volatility
Every mutual fund marketing includes the well-known warning, "Mutual fund investments are subject to market risk."
Losses happen when the market performs poorly. The success of the market is influenced by several variables. For instance, market performance is significantly impacted by factors such as inflation, recession, interest rate variations, political turmoil, natural catastrophes, etc. In 2020, the COVID-19 epidemic had an impact on Indian markets. The Indian stock market has seen a severe collapse. Systematic risk includes market risk. You aren't really able to do anything about it. The best course of action is to watch the markets.
2. Liquidity Risk
The danger of being unable to sell your investment in times of need is known as liquidity risk. Or it might be the challenge of withdrawing money from an investment without suffering a loss. ELSS is a three-year lock-in tax-saving mutual fund programme. Liquidity risk is a result of this lock-in time. The fund units cannot be redeemed while the lock-in term is in effect.
Another type of liquidity risk was encountered by Exchange Traded Funds (ETF). After their issuance, ETFs are traded on the stock exchange. Finding prospective buyers or sellers of the ETF on the stock exchange is sometimes challenging. Due to the low transaction volumes, it could be challenging to exit when necessary.
3. Risk of Concentration
Concentration risk is the term for having a significant exposure to one certain asset, industry, or subject. You have a high-risk portfolio, for instance, if your investment portfolio includes a large exposure to stock schemes. When markets are erratic, there is a considerable likelihood of losing money. This is a result of the equity scheme's high level of concentration. You will need to implement various diversification techniques to handle this.
4. Rate of Interest Risk
Interest rates are occasionally revised by the Reserve Bank of India. The price of a securities is impacted by changes in interest rates. Bond prices and interest rates go hand in hand. Bond prices decrease in response to a rise in interest rates. Similar to this, bond prices rise when interest rates drop. As a result, changes in interest rates have an effect on the financial instrument's value.
5. Credit Danger
The inability of the borrower or the issuer to pay the interest is known as credit risk. Based on a number of factors, the asset is rated by credit rating agencies. Bonds with high ratings pose less credit risk. Low-rate bonds also carry a significant credit risk. In other words, a credit rating suggests that a borrower or issuer will be able to make interest and principal payments. Low default probability are implied by a high rating and vice versa.
6. Inflation Risk
As prices rise, buying power declines. When investing in any asset, one should consider the danger of rising inflation. Always invest in plans that produce returns that outpace inflation. If the returns on your investments are not more than the current interest rate, then you are just losing money on your investment. The best illustration of money losing value over time is holding idle cash. For instance, if inflation is around 6% and your investment is yielding a 7% return, your actual return is only 1%.
7. Cash Flow Risk
Exchange rate changes are referred to as currency risk. Returns on investments will decline if the exchange rate declines. For instance, when the value of a fund denominated in a foreign currency increases, the investment's worth at redemption decreases. In other words, it yields a lesser rate of return when translated to INR.
8. Risk of Rebalancing
The mutual fund investments are regularly rebalanced and reviewed by the fund management. On the other side, frequent reinvestments run the risk of missing out on opportunities for investment growth. Additionally, frequent rebalancing will raise the management fees for the fund.
9. Risk of Management
Investments in mutual funds are subject to management risk. The probability that the fund manager would perform worse than the benchmark is known as management risk. One way to reduce management risk is to invest in index funds. But in terms of returns, the index fund will never outperform the market.
10. Regulatory Risk
As the name implies, regulatory risk is a kind of risk that is dependent on government pronouncements and rules. The value of your investment will be impacted by any rule or regulation that might harm the industry in which you have investments. Your investments in coal and funds connected to thermal power, for instance, may suffer if the government introduces legislation prohibiting the development and use of non-renewable energy sources, such as thermal energy.
Risk Mitigation Techniques
Risk will always exist. However, what counts is how you manage the risk. Investments in mutual funds involve a risk. However, they have the capacity to produce substantial growth. Your objectives will be achieved via a carefully implemented investment plan. You may lower the risks of investing in mutual funds by using the following strategies:
1. Make a diverse investment portfolio
It's crucial to choose the funds that are appropriate for your degree of risk tolerance. You must, however, make sure that your investing portfolio doesn't focus just on one type of asset, subject, or industry. Maintaining the best possible balance between the asset types in your investing portfolio is a wise strategy. Consider your investing horizon, risk tolerance, and goals before selecting funds that will perform well even when the market is volatile.
2. Plan for Systematic Investments (SIP)
You may smooth out market volatility by investing through a SIP. To give an example, assume that a mutual fund's NAV is INR 100 and that you invest INR 10,000. (100 units). When the fund's NAV reaches 110 the next month, you will only have 90.91 units scheduled for your 10,000 INR SIP contribution. The NAV drops to INR 80 the next month, and you will now receive 125 units for your SIP payment. As a result, by investing through a systematic periodic payment (SIP), you will amass more units when the NAV declines and profit from price gain when the NAV rises. Ultimately, frequent investing will allow you to average out the price swings. You will gain from rupee cost averaging and compounding when you use SIP.
3. Plan for Systematic Transfer (STP)
STP investing lowers average transaction costs while also assisting in reducing the risk of mutual fund investments over time. It aids in reducing the negative impacts of entering an overvalued market. You should have the option to change funds since it helps to successfully consolidate profits and lowers related risks.
