Disclaimers aren't usually hardwired in people's minds unless you're talking about "Mutual Fund investments are subject to market risks, read all scheme related documents carefully". Thanks to this disclaimer, everyone knows returns on mutual funds are volatile. However, few know the risks it talks about and their impact on your mutual fund portfolio. This article provides insight into the risks of investing in mutual funds.
What are the risks associated with investing in mutual funds?
Here are the risks associated with investing in various types of mutual fund schemes in India:
The performance of the market affects the performance of a mutual fund scheme. Many factors affect the market's overall performance, including political unrest, fluctuation of interest rates, a national disaster, inflation, recession, etc. Market-related risks severely impact your mutual fund scheme’s returns, although you can mitigate them by investing according to your risk profile and diversifying your portfolio.
Portfolio diversification mitigates concentration risk, which is the risk an investor assumes by investing in a single sector or mutual fund segment. An example of a concentration risk is investing capital in a particular segment, such as small-cap mutual fund schemes. You can eliminate concentration risk by diversifying your portfolio ie by investing in schemes investing across sectors and in amix of small-cap, mid-cap, and large-cap mutual fund schemes.
3. Interest rate
Investors must know the risk arising from interest rates. Returns in debt mutual fund schemes may vary depending on the prevailing interest rates. If the interest rates change, the price of the underlying stocks or debt instruments also changes. The NAV of the Scheme(s) is expected to increase from a fall in interest rates while it would be adversely affected by an increase in the level of interest rates.
Liquidity risk is the risk of redeeming an investment with minimal or no loss. The mutual fund company informs the investor about a possible liquidity risk before investing in a mutual fund scheme. Schemes such as ELSS (Equity Linked Savings Schemes) have a lock in period during which the investor cannot redeem their funds. Hence, mutual fund schemes with a long-term lock-in period carry certain liquidity risks. In case of ETFs Schemes (Exchange-Traded Funds), substantial gaps in buy and sell price on the exchange can lead to liquidity risk.
Debt funds come with credit risks. If an issuer of fixed income securities fails to meet interest and principal payments obligations , it translates to a credit risk. Hence, debt mutual fund managers generally include investment-grade securities with high credit ratings which can reduce the possibility of default.
Inflation affects the health of the nation's markets. As the name implies, it is a way of indicating the risk that inflation can pose to the portfolio over time. Inflation riskis another uncertainty that must be considered when choosing a mutual fund scheme.
7. Currency risk
Currency riskis the risk arising from an increase in the value of foreign currency-denominated funds resulting in a decrease in foreign currency. Currency risk is an essential factor to be considered when opting for debt funds, and it directly lowers the rate of returns when exchanged into INR.
How to mitigate these risks?
Mutual funds are challenging but rewarding. Here is how you can mitigate the risks in mutual funds:
1. Conduct a risk assessment and
structure your portfolio accordingly
Understanding your temperament as an investor goes a long way in helping you structure your portfolio in alignment with your returns-related expectations. Your risk assessment capability depends on various factors, including age, financial standing, and goals. Contact a financial advisor and chalk out a plan to properly structure your investment portfolio.
2. Go the SIP
A Systematic Investment Plan (SIP) is helpful because it gives your investments a structure and helps you invest in a disciplined fashion. If you are investing in a mutual fund scheme, opting for a SIP can be a good idea to grow your wealth over time and get the benefit of rupee cost averaging.
3. Consider investing through
Pursuing a Systematic Transfer Plan (STP) can be beneficial if you understand your are clear about your financial goals. If you wish to transfer a part of your investment to another mutual fund scheme, you can do so through STP.
Ensure you make changes to your portfolio over time by zooming out and analyzing your investments. Moreover, ensure to spread your investments across asset classes, sectors and market capitalizations with an aim to mitigate risk.
Bear the points mentioned in this article in mind before investing in any mutual fund scheme for making the right and informed investment decision.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.