Understanding Risks in Mutual Funds

Understanding Risks in Mutual Funds

Gone are the days when people just used to invest in traditional FDs and Gold. Millennials and Genz are more aware of their finances and do invest in stocks and mutual funds. Mutual funds give higher returns as well as diversify your portfolio. But it also carries risk like all other investments.

An investor can make himself aware of these associated risks and plan the investments accordingly. This will reduce the overall risk and help him gain higher returns.

In this article, we will understand what kind of risks are involved with mutual fund investments. There are two basic categories of mutual funds i.e., Equity Mutual funds and Debt mutual funds. Both types carry different types of risks.

Equity mutual funds carry the risk of volatility and liquidity. On the other hand, debt mutual funds carry the risk of interest rate, inflation, rebalancing etc.

How Mutual Funds are Risky Investment?

Mutual fund money is invested in various financial instruments like stocks, bonds, government securities etc. All these financial instruments tend to fluctuate due to various factors like interest rates, Government policies, taxation etc.

This results in a fall in the NAV of the mutual fund scheme. Due to this investor faces loss. This risk can be reduced if investors understand properly the risk associated with the mutual fund schemes.

Types of Risks

Equity mutual funds and Debt mutual funds carry different kinds of risk. Below are mentioned the various types of risk involved while investing in mutual funds:

Risk in Equity Mutual Funds

1. Volatility Risk: Equity mutual funds invest in stock markets. Stock markets are very volatile. The price of stocks keeps fluctuating due to various factors like changes in government policies, inflation, recession, economic cycle, RBI policies etc. This leads to ups and down in the NAV of mutual funds.
2. Liquidity Risk: When you invest in Equity related schemes you carry the liquidity risk. For example, ELSS funds come with a liquidity risk. It has a lock-in period. An investor can’t do anything with the investment during this time. In addition to this, investors may find redeeming it a bit tough as per their suitable time.
3. Risk of Money Loss: If you invest in equity and equity-related schemes then you carry the risk of losing all your money. You shall invest in equity only if you can face the risk of losing all your money.

Risk in Debt Mutual Funds

1. Interest Rate Risk: Interest rate keeps on changing depending on the demand for credit as well as credit available with lenders. RBI keeps on changing the interest rates. As a result of which the value of your debt fund may fluctuate. Interest rates and bond prices are inversely proportionate to each other. When the rate of interest increases the price of bonds decreases and the value of the bond also falls.
2. Credit Risk: At times the issuer of a mutual fund scheme may fail to pay the promised interest. This is defined as credit risk. Under debt funds, fund managers generally prefer investments with high credit ratings. But to generate higher returns they at times invest in low credit-rated schemes. In such scenarios, there is a risk involved in not getting returns.
3. Inflation Risk: Inflation risk is the risk when one loses his purchasing power due to rising inflation. If the returns on your investment are lower than the inflation rate then you are making a loss from your investment. Investors while investing must keep in mind the rising inflation.

Ways to Reduce the Risk of Investing in Mutual Funds

We have now understood that mutual funds carry risk. Now let’s understand how can this risk be reduced:

1. Invest as per Your Risk Appetite: One shall understand his/her risk appetite and plan the investment strategy accordingly. Choose the scheme that matches your investment goals. People who are low-risk takers shall invest in both equities as well as debt mutual funds.
2. Invest in SIPs: To invest in SIPs, you don’t require huge funds. You can start a SIP with a nominal amount of ₹500 also. The risk burden reduces here significantly.
3. Invest in long term: Invest in mutual funds for the long term. This will help you reduce the risk of short-term fluctuations. At the same time, it will also help you earn more due to the compounding effect.

Conclusion

After reading this article you are aware of the risks involved in investing in mutual funds. You as an investor can reduce the impact of risk by properly planning your investments. Determine your goals and risk appetite and invest accordingly.