“Mutual fund investments are subject to market risks, read all scheme related documents carefully”
You would have heard this sentence probably 1000 times before and yes, you have heard it right. Like every other investment, mutual fund investments are subject to risks. This is because there is no way to predict what will happen in the future; whether given asset class will increase or decrease in value. This is applicable to all asset classes. But then you would ask why only mutual fund ads carry this disclaimer and why not fixed deposit or gold or real estate ads? Does it mean other investment options are safer than mutual fund? What are the risks of investing in mutual fund? Is there any way of mitigating them?
As I said, all asset classes are subject to market risks and mutual fund is nothing but an investment vehicle which invests in different asset classes; primarily equities and bonds. Each asset class has different type of risks associated with them and generally; higher the risk, higher is return! Equity asset class has higher market risks but lower interest rate risks than bonds. Quantum of risk is often dependent on holding period of asset class. In case of equity, higher the holding period, lesser is market risk. Let’s learn about type of risks one by one and try to find out ways of mitigating them.
- Market Risks – There are many factors that affect markets. Economy, political situations, natural disasters and pandemics! We have seen how COVID-19 impacted markets. Market risks affect all asset classes, but impact is generally higher in equities as equity investments especially in shorter time frame are often sentiment driven! The only thing that an investor can do in market risk situations is to wait for things to fall in place and stay invested for a decided horizon rather than redeeming in panic. Economies all over the world have always recovered from recessions and even depressions in the past!
- Liquidity Risks – Liquidity risk is a risk associated with ability of buying and selling investment especially in declining markets. Equities and bonds (and so mutual fund which predominantly invest in equities and bonds) are superior asset classes than real estate and gold in terms of liquidity risks. Lock-in period for a mutual fund scheme may result in liquidity risk as units cannot be sold in lock-in period; so be watchful of it!
- Credit Risks – Credit risks are specific to bonds and occur when issuer of bond is unable to pay what was promised as interest. Any mutual fund investing in bonds suffer from credit risks; degree of this risk however varies from scheme to scheme and can be gauged from credit ratings of the portfolio. Each bond in mutual fund scheme portfolio has rating. Fund manager tries to include only high rated bonds but sometimes it might happen that to earn higher returns; the fund manager may include lower rated bonds. Thumb rule of higher risk higher returns also applies to individual bonds and it is a good practise to align your return expectations to associated risks by looking at credit ratings.
- Interest Rate Risks – Interest rate risks are risks associated with changes in interest rates. Interest rates impact all asset classes, but risk is highest in bonds especially in long term bonds. When interest rates rise, price of existing bonds fall as new bonds with higher interest rates become more attractive. Fund managers and investors try to sell them and prices of those decrease. Only way to reduce interest rate risk is to diversify bond mutual fund portfolio by investing in bonds of different durations.