Mutual funds are subject to market risks. These risks arise owing to the fact that mutual funds invest in a variety of financial instruments like debt, corporate bonds, equities, govt securities etc. On top of that, the price of these instruments keeps fluctuating because of a lot of factors like change in interest rate, inflation, supply-demand etc. Due to fluctuations in price, your NAV comes down resulting in a loss. Hence, before going for mutual fund investments, one must identify the risk-profile and invest in appropriate funds.
Your mutual fund investments can be summarized into 2 words, i.e, risk and reward. The general idea is greater the prospective reward, greater is the risk. However, it does not apply the other way around, i.e, higher risk does not necessarily mean higher potential reward, unless you know the tricks to mitigate the risk. Let’s look at the type of risks associated with mutual fund investments.
- Market Risk: Market risks are associated with poor performance of the market, which may result in losses for any investor. There are a lot of factors that may affect the market like inflation, natural disasters, political unrest, interest rate fluctuation, recession and other factors. Diversifying your portfolio will not help in this case but what you can do is wait for the storm to pass and reduce the chances of being hit by market risks.
- Concentration Risk: Concentrating a huge amount of one’s investment in a single scheme is not healthy. If lucky, profits will be huge but losses will be more. Best way to minimize this risk of concentration is by diversifying your portfolio. Concentrating and investing heavily in one sector is also highly risky. The more diverse the portfolio, lesser the risk is.
- Interest Rate Risk: Interest rates change depending upon the available credit with lenders and demand from borrowers. These are inversely proportional to one another. Increase in the interest rates during the investment period may result in a reduction of the price of securities. Take for example, Mr. A decides to invest Rs 100 with a rate of 5% for a period of X years. If the interest rate varies due to changes in the economy and goes upto 6%, A will no longer be able to get back the Rs 100 he invested owing to the fact that the rate is fixed. The only option here is reducing the market value of the bond. If the interest rate reduces to 4% on the other hand, the investor can sell it at a price above the invested amount.
- Liquidity Risk: It refers to the difficulty to redeem an investment without incurring a loss in the value of the instrument. It can also occur when a seller is unable to find a buyer for the security. In ELSS, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. You might be unable to redeem your investments when you need them the most, due to lack of buyers in the market. The best way to avoid this is to have a very diverse portfolio and making fund selection diligently.
- Credit Risk: Credit risk means the issuer is unable to pay what was promised as interest. Mutual funds suffer credit risk. In debt funds, the fund manager has to incorporate only investment-grade securities. But sometimes it might happen that to earn higher returns, the fund manager may include lower credit-rated securities. This would increase the credit risk of the portfolio. Before investing in a debt fund, have a look at the credit ratings of the portfolio composition.
How can you reduce investment related risks?
You must factor in your financial position, age and expected income growth in the near future to assess your risk appetite. You must tailor your investment portfolio based on your risk tolerance level. For example, investors with moderate to high risk appetite would invest largely in equities to achieve their long-term goals. The ones with low risk appetite investors prefer balanced portfolio, which would involve a mix of both debt and equity, even for their long-term financial goals. Next step to avert risk is to know when to invest in NFOs. NFOs are the first-time subscription offer for any new mutual funds offered by AMCs to the public.
Opt for a particular NFO only if it comes with unique offerings that suit your risk appetite and financial goals. Invest in a systematic investment plans as they are predetermined amounts that are invested in selected schemes at regular frequencies regardless of the current NAV or market level. SIP includes the concept of rupee cost averaging, which averages out the cost at which investors purchase units over time with zero need to time investments and monitor the market. More units are bought when market prices are low and fewer units are bought when the prices are high. Other ways to avoid market risks are considering asset allocation strategy and building a diversified portfolio.
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