1. Why is mutual fund investment risky?
Risk arises in mutual funds owing to the reason that mutual funds invest in a variety of financial instruments like equities, debt, corporate bonds, government securities and many more. Moreover, the price of these instruments keeps fluctuating owing to a lot of factors like supply-demand, change in interest rate, inflation, etc
Due to price fluctuation or volatility, a person’s Net Asset Value comes down, resulting in a loss. In simple terms, NAV is the market value of all the schemes a person has invested in per unit after negating the liabilities.
Hence, it becomes essential to identify the risk profile and invest in the most appropriate fund.
2. Types of risks associated with mutual funds
a. Market Risk
We all would have seen that one-liner in all advertisements that mutual funds are subject to market risk.
Market risk is a risk which may result in losses for any investor due to the poor performance of the market. There are a lot of factors which affect the market. A few examples are a natural disaster, inflation, recession, political unrest, fluctuation of interest rates. Market risk is also known as systematic risk. Diversifying a person’s portfolio won’t help in these scenarios. The only thing which the investor can do is wait for the storm to calm.
b. Concentration Risk
Concentration generally means focusing on one thing. Concentrating a considerable amount of a person’s investment in one particular scheme is not a good option. Profits will be huge if lucky, but the losses will be more. Best way to minimize this risk is by diversifying your portfolio. Concentrating and investing heavily in one sector is also very risky. The more diverse portfolio, the lesser the risk is.
c. Interest Rate Risk
Interest rate changes depending upon the credit available with lenders and the demand from borrowers. They are inversely related to each other. Increase in the interest rates during the investment period may result in a reduction of the price of securities.
For example, an individual decides to invest Rs.100 with a rate of 5% for a period of x years. If the interest rate changes due to changes in the economy and it becomes 6%, the individual 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 thebond. If the interest rate reduces to 4% on the other hand, the investor can sell it at a price above the invested amount.
d. Liquidity Risk
Liquidity risk 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 mutual funds, like ELSS, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. In yet another case, Exchange traded funds (ETFs) might suffer from liquidity risk. As you may know, ETFs can be bought and sold on the stock exchanges like shares.
Sometimes due to lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and to make fund selection diligently.
e. Credit Risk
Credit risk means that the issuer of the scheme is unable to pay what was promised as interest. Usually, agencies which handle investments are rated by rating agencies on these criteria. So, a person will always see that a firm with a high rating will pay less and vice-versa.
Mutual Funds, particularly debt funds, also suffer from 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, and 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.
So, right now, you are aware of the risks that are linked with mutual funds. Head to ClearTax Invest where you can invest in mutual funds. You can either grow your wealth or save taxes with us.