Investing in mutual funds is a strategy for individuals seeking portfolio diversification and professional fund management. Even though they have the potential to offer higher returns, there are certain risks associated with them that investors should be aware of. Hence, understanding the factors contributing to these risks is crucial for investors to decide about their financial portfolios.
Why are Mutual Fund Investments Risky?
Mutual fund investments carry inherent risks due to their exposure to various market dynamics. Market volatility, economic uncertainties, and factors influencing individual securities within every fund can contribute to fluctuations in its net asset value (NAV). Additionally, the diverse range of assets, like stocks, bonds, commodities, government securities, etc., within a mutual fund introduces complexity and exposes investors to different types of risks.
Types of Risk Associated with Mutual Funds:
1. Market Risk:
The performance of the financial markets can directly impact the value of mutual funds. Fluctuations in stock and bond markets can result in gains or losses for investors. For instance, inflation, recession, COVID outbreak, natural disasters, etc., significantly impact the market performance. Thus, investors should always watch the markets during such situations.
2. Concentration Risk:
Schemes focused on specific sectors or industries are susceptible to concentration risk. Any changes in those sectors can disproportionately impact the fund's performance. For instance, investing in schemes focussed on the banking sector and any bad news about any bank can negatively impact the portfolio. Hence, diversification is the key to avoiding this risk.
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3. Interest Rate Risk:
Bonds are very sensitive to any change in interest rates. A rising interest rate can lead to a decline in the bond price and vice-versa. Therefore, any change in the interest rate can affect the overall value of the fund.
4. Inflation Risk:
Inflation erodes the purchasing power of money. Hence, investing in funds that can provide inflation-beating returns is a way to tackle inflation risk. For instance, if your investment generates 8% and inflation is 6%, your actual earning is only 2%.
5. Credit Risk:
Investing in lower-rated or riskier securities exposes the mutual fund scheme to credit risk. If issuers default on these securities, it can result in financial losses for the fund. Therefore, investing in schemes with higher credit ratings lowers your chances of loss.
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6. Liquidity Risk:
Some funds, like ELSS funds, have a lock-in period of 3 years where you can only redeem your investments after 3 years. Similarly, ETFs, traded on the stock exchange, can sometimes be difficult to trade when volumes are low. Therefore, diversifying your investments and making a portfolio per your financial needs is essential.
7. Currency Risk:
International funds are subject to currency risk as exchange rate fluctuations directly impact the value of foreign investments when converted back into the investor's currency. For instance, when the value of the foreign currency rises, when converted to INR, it will lower the return.
8. Management Risk:
The success of a mutual fund often depends on the fund manager's skill and decision-making. Managerial changes or suboptimal strategies can impact fund performance.
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9. Regulatory Risk:
Any change in financial regulations or tax laws can affect how mutual funds operate, influencing their structure and potential returns. For instance, if the government passes any regulation related to the restriction on the production of tyres, then any investment in auto-mobile or tyre-related companies is negatively impacted.
Tips to Mitigate Risk in Mutual Funds
To mitigate these risks effectively, investors can consider the following tips:
Diversification:
Spreading investments across various asset classes/sectors can reduce exposure to any single risk factor. Hence, create optimum balance across asset classes in your investment portfolio. Also, consider your financial goals, investment horizon and risk tolerance level while selecting funds. Pick funds that can perform even during the market turmoil.
Regular Portfolio Review:
Periodically reassess and rebalance your portfolio to align with your risk tolerance and investment goals. Also, check for funds that are underperforming due to several factors. You can consider redeeming/switching them to better-performing funds.
Invest through SIPs:
A systematic investment plan (SIP) allows you to regularly invest in mutual funds in small quantities without timing the market. Thus, the investment cost is averaged out, benefiting you from the rupee cost-averaging strategy. This is the most effective way to mitigate risk in mutual funds.
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Risk Tolerance Assessment:
Understand your risk tolerance level and select funds that align your comfort level with risk. For instance, higher risk can give higher rewards, but there is no guarantee. Hence, create a portfolio to match your risk profile or take the help of experts.
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Conclusion
While mutual funds offer a convenient way for investors to access diversified portfolios, considering the risk associated with them is also important. By understanding the diverse risks and implementing proactive risk management strategies, investors are prepared to handle the dynamic market conditions while investing in mutual funds. Moreover, regular monitoring and staying informed are essential to a successful and risk-aware investment approach.
Our team of experts at Sigfyn can also help you build a customised portfolio based on your risk tolerance level and consider various factors necessary to grow long-term wealth. Join us now!
