Understanding the Risks in Your Mutual Fund Investments


Equirus Wealth

05 Dec 2022 5 min read

Risk Management#Investment#Mutual Funds

A mutual fund can combine your funds with other investors and have a professional handle the fund. They are in the form of bonds, stocks, and equity. Data from the Association of Mutual Funds in India show that in FY22, the industry welcomed over 10 million new investors and collected Rs 1.2 trillion in total through SIPs. However, you should know the hazards associated with investing in mutual funds.

Why is Investing in Mutual Funds risky?

As mutual funds engage in a wide range of financial assets, including debt, equities, corporate bonds, and government-backed securities (or financial instruments), the risk is there regarding mutual funds.

Numerous factors influence the price of these instruments and have a greater likelihood of losing money than making them. You will almost certainly see losses mounting if you don't stay invested. Therefore, it is crucial to determine the risk profile and invest in the best fund.

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What are the Risks of Investing in Mutual Funds?

The risks associated with Mutual Funds are as follows:

Volatility Risk

An equities mutual fund's investment value drops if the entire market experiences a downturn. They are also known as Systematic risks. A variety of factors impact any security market. Important variables include natural catastrophes, fluctuating interest rates, inflation, recession, conflicts, political unrest, shifting population demographics, and geopolitical concerns.

Liquidity Risk

Depending on the volume of transactions in the market, liquidity risk is the ease with which you can sell an asset or close to its fair value. Another type of liquidity risk was encountered by Exchange Traded Funds (ETF). After their issuance, ETFs are traded on the stock exchange. Finding prospective buyers or sellers of the ETF on the stock exchange is frequently challenging.

Interest Rate Risk

Changes in interest rates impact the price of a security. hedge fundsBond prices and interest rates go hand in hand. So, Bond prices decrease in response to a rise in interest rates. Similarly to this, bond prices rise when interest rates drop. As a result, changes in interest rates affect the financial instrument's value.

Currency Risk

Currency risk is the possibility of profits or losses resulting from changes in various currencies. Everyone is susceptible to the effects of currency risk, including governments, international corporations, and tourists traveling abroad.

Credit Risk

Based on several factors, the asset is rated by credit rating agencies. Bonds with high ratings pose less credit risk. Low-rate bonds also carry a high credit risk. There is a credit risk when the security issuer cannot pay the interest as promised. Debt funds that invest in bonds with weaker credit ratings run a higher risk.

Regulatory Risk

As the name implies, regulatory risk is a category dependent on government announcements and rules. The value of your investment will be impacted by any law or regulation that could harm the industry in which you have assets.

Concentration Risk

Concentration risk is the term for having significant exposure to one particular asset, industry, or theme. Concentrating a sizable portion of your investment on a single asset or asset type is not a good idea. Profits might be phenomenal if the market favors the collection of assets. If the tide for that particular item or combination of assets flips, there could also be substantial losses.

Inflation Risk

The danger of potential loss of your investment's buying power due to an overall rise in consumer prices is known as inflation rate risk or purchasing power risk. Fixed-income investments enable a clear understanding of inflation risk. The nominal return on your investment is if you purchase a bond with a 3% coupon rate. However, if inflation is 2%, your actual increase in purchasing power is only 1%.

Management Risk

Any mutual fund's performance depends on the manager's experience, knowledge, skill, and investment techniques/process. If any of these factors are lacking, the fund's performance will suffer, which will be bad for unit holders.

Rebalancing Risk

Mutual fund investments are regularly rebalanced and reviewed by the fund managers. On the other side, frequent reinvestments risk missing out on opportunities for investment growth. Additionally, periodic rebalancing will raise the management fees for the fund.

What are the Ways to Overcome Mutual Fund Risks?

The best possible ways to overcome Mutual Fund Risks are as follows:

  1. Recognize your level of risk tolerance so that you may make investments based on the optimum risk-return trade-off for reducing investment risk.
  2. Keep enough liquid assets in your portfolio. Liquid and Overnight Funds, two low-risk investment options, should be available in our accounts.
  3. Invest in various asset types, such as equity, debt, mutual funds, real estate, gold, etc., and have an asset allocation strategy.
  4. It would be best to have fund managers with extensive experience to help you make investment decisions.
  5. Portfolio diversification to lower total investment risk.
  6. You must routinely monitor the performance of your portfolio and conduct cyclical reviews.
  7. Invest in a blue-chip stock or fund to reduce liquidity risk.

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Final Thoughts

Each kind of mutual fund has a unique risk and return potential profile. It's critical to comprehend these risks and potential rewards before investing in a mutual fund.