Understanding risks related to mutual funds
February 17, 2020
Investment through a structured planning process is one of the most-rewarding trajectories towards your financial goals. The returns of an investment are guided by the risk-factor associated with the asset.
Similarly, investing in mutual funds also holds some degree of risk which depends on the nature of the security. Equities are known to possess a great degree of risk and thus deliver good returns. Debt funds possess a significantly lower amount of risk and hence deliver relatively lower returns.
No matter where we are, what we are doing, we are always juggling risks. In fact, not taking any risk is the biggest risk in itself! Instead of playing it safe, embrace risk and capitalize on it by understanding its nature and mitigating it. This will put you in a better position to achieve your financial aspirations.
Let’s dive deeper into the type of risks associated with mutual funds.
1. Market risks
“Mutual funds are subject to market risks”
No, this is not another MF commercial but rather a fundamental truth! Mutual funds are essentially linked to the financial market. Any shift in the market is cascaded to the mutual fund industry. For example, a slowdown in the economy will affect the performance of Mutual Funds thereby resulting in a possibility of low/negative returns.
Other factors may include financial crisis, government reforms, economic conditions and other macroeconomic factors which inadvertently affect the market. One way to sail through the market risk is to stay invested over a long-term.
2. Interest Rate risk
Changing interest rates affect a variety of financial instruments and Mutual Funds are no different. It is the debt funds that are linked to the interest rate fluctuations; there exists an inverse relationship between the two variables. When the interest rate rises, the price of fixed income securities like bonds fall and value of the securities dips. On the other hand, a fall in interest rates pushes up the price of Mutual funds.
3. Credit risk
Imagine you advance a loan of ₹1000 to a friend for a period of 7 days. After 7 days, your friend fails to pay you back as he has run out of money. This is known as credit risk. It refers to the risk of failure of payment by the issuer of the security.
The credit-worthiness of debt funds depends on the issuer and the credit rating of the securities. These credit ratings are issued by credit rating agencies like CRISIL, CARE, ICRA etc., range from (ranging from AAA to C and D). A higher rated debt instrument features higher credit-worthiness than lower-rated securities.
4. Inflation risk
Inflation is the chief enemy of all consumers and investors. Despite being an indicator of economic growth, it erodes our purchasing power i.e the value of money. For simplicity, let us assume our nominal return on investments to be a cake with 6 slices. Inflation eats up a slice of your cake and you are left with just 5 slices i.e. your real return.
Fortunately, not every type of mutual fund is susceptible to every kind of risk. Equity funds, for example, are subject to market risk but help protect against inflation risk, if invested over a long period. Similarly, fixed-income funds are susceptible to interest-rate risk but offer some protection against market risk. By diversifying, you can alleviate the negative impact of risk on your portfolio as a whole.