Mutual funds are among the most transparent and convenient investment options. Investors have a wide variety of schemes to choose from, a fund manager takes charge of investment decisions, and the long-term prospects tend to be favorable. However, mutual funds do come with an element of risk, and understanding these risks could help investors make informed choices when choosing the most suitable schemes to meet their investment goals.
Types of Risks in Mutual Funds
There are different types of mutual funds like equity funds, debt funds, etc. In this blog article, we will be breaking down some of the risks associated with equity and debt mutual funds.
Equity Mutual Funds
Equity mutual funds predominantly invest in equity shares of companies that are listed on the stock market. Owing to this relationship with the markets, they also experience the associated risk.
Market risk: Market risk occurs when the stock markets undergo high volatility. Market risks can be systematic risks or unsystematic risks. Systematic risk affects the stock market as a whole and is typically caused by external events like political changes, natural disasters, new policies, changes in exchange rates, etc.
On the other hand, unsystematic risk is more centered on individual stocks or sectors and is caused by internal factors. These factors could include management changes within a company, the launch of a new competitive product in the market, and policy changes that affect a particular sector like changes in a trade agreement with a country exporting a particular raw material to India.
During periods of volatility, markets may take a sharp downturn thereby resulting in a decrease in the price of stocks. In turn, this affects the NAV or net asset value of a mutual fund scheme, potentially making it lower than what it was at the time of investment.
Concentration risk: Concentration risk is the result of an investor putting all their money in just one scheme or one sector. If that scheme or sector suffers losses for any reason, then the investor has no cushion for their investment but could stand to lose everything that they invested.
When it comes to mitigating risk in equity mutual funds two actions could make a big difference in balancing out the risk with the returns:
- Investing in a diverse portfolio: Spreading the investment over multiple schemes so that even if a few schemes or a sector are not performing well, the investment capital is still protected due to the diversification of the portfolio.
- Staying invested for the long-term: Equity schemes have shown to perform better over longer durations. By staying invested in these schemes for at least five years, investors have a chance to overcome short-term market fluctuations and take advantage of the overall growth of the economy.
Debt Mutual Funds
Debt mutual funds invest in debt securities like government bonds, corporate papers, treasury bills, etc. Debt funds could be susceptible to two main types of risks.
Interest rate risk: Interest rate risk is caused by fluctuations in the interest rate of debt bonds. When an investor invests in debt, they are effectively lending money to a company or organization. In return, the company promises to pay the loan amount back within a certain time and at a certain rate of interest. The rate of interest is fixed for the duration of the investment. If during the time that the investor is holding the debt bonds, the interest rates of fresh bonds increase, then the bonds in holding lose some of their value.
Credit risk: Credit risk occurs when the company that issues the bonds is unable to pay back the borrowed amount. This is more likely to happen with companies that have a lower credit rating and are not very well-established. Credit risk can be minimized to some extent by investing in government-backed bonds or bonds of companies with a high credit rating and a good track record of paying creditors back.
It is not possible to eliminate investment risk as financial instruments are constantly affected by both internal and external factors. However, being aware of the risk can help investors make smarter investment choices in line with their goals and risk-taking capacity.
Article Shared by ICICI Prudential AMC