Understanding the Risks in Investing in Mutual Funds: A Guide for 2024

Mutual fund investments look very appealing, considering their diversification and professional management. But like every investment, mutual funds do carry its share of risks that investors should be informed about before making any moves. Here’s an elaboration on some of the risks associated with mutual fund investments so that you know how to minimize them.

What Are the Risks in Mutual Funds?

Investment in a mutual fund is no risk-free. The primary source of risk will result from the floating value of these underlying assets like equity, bonds, or any other instruments. The underlying assets may float due to the following reasons: market conditions, interest rates, and/or credit events. The knowledge of these risks can lead to better selection of investment.
Types of mutual fund investment risks include several kinds of associated risks. Some are systematic, that means affecting the market as a whole, while others have unsystematic and specific risk associated with individual investments.

1. Market Risk

Market risk, also known as systematic risk, is one that affects the entire market and is due to macroeconomic factors such as the change in interest rate, inflation, or political instability. Since a mutual fund invests in a wide range of securities, it is responsive to such wider changes in the market.

Example: Due to economic instability resulting in the stock market crash, the value will decline in equity mutual funds and everyone will bear the loss.

2. Credit Risk

Credit risk pertains especially to debt mutual funds. It arises due to default by the issuer of a bond or security in which the fund had invested regarding a failure to pay interest or return of the principal amount.

Example: A company whose bonds were held in a debt fund experiences financial distress. In such an event, it may go into default, and hence, a loss for the fund.

3. Interest Rate Risk

Bond and debt mutual funds are linked with the risk of interest rates. The price of bonds falls down while the interest rate moves upwards and vice versa. Returns from debt funds get dragged down due to the adverse relation.

Illustration: Due to the rise in interest rate by RBI, the price of the debt mutual fund’s bonds might decline, and hence losses to the investors may occur.

4. Liquidity Risk

Liquidity risk arises when a mutual fund cannot sell its assets quickly enough to meet redemption. The risk is high for funds that are invested in illiquid securities, such as small-cap equities and long-term bonds.

Example: When a mutual fund has a significant investment in small-cap companies and a group of investors decides to withdraw simultaneously from the investment, the fund cannot sell their stocks quickly without sustaining heavy losses.

5. Inflation Risk

Inflation risk occurs when the return from an investment fails to keep pace with the inflation rate, thereby eroding the purchasing power of your investment, and is more evident in debt mutual funds when the returns are low compared to an equity fund.

Example: Where a debt fund pays a yield of 5%, but the inflation rate is 6%, the real return from that investment would be negative, hence decreasing your purchasing power.

6. Currency Risk

Currency risk refers to the situation where mutual funds invest in international markets. If there are fluctuations in foreign exchange rates, they could devalue overseas investments when they are turned into the home country’s national currency.

Example: If the Indian rupee appreciates against the U.S. dollar, the returns from U.S.-based investments in a mutual fund could diminish when converted back into rupees.

7. Concentration Risk

Concentration risk arises when a mutual fund invests extremely heavily in a particular sector, stock or asset class. This lack of diversification simply magnifies the risk if that specific investment performs poorly.

For instance, if a mutual fund invests heavily in the technology industry, then when that sector breaks down, so will the mutual fund.
8. Rebalancing Risk
Rebalancing risk can simply be described as the loss incurred due to too frequent changes in the portfolio carried out by fund managers. Rebalancing is linked with the adjustment of asset allocation within a fund towards a defined investment goal, but excessive rebalancing results in an increase in costs and missed growth opportunities.

Example: If an investor keeps on switching from stocks to bonds or vice versa based on the movements of the market, then the transaction cost would be high with long-term growth prospects of being missed.

How to Minimize Risk of Mutual Funds

Nothing is risk-free, but you can do several things to reduce the impact of these risks on your mutual fund portfolio.
Diversify Your Portfolio
Diversification – the right way to reduce risk is to diffuse your investments across asset classes, sectors, and geographies. This way, you minimize the fall into a specific downturn in any one space.

Illustration: Invest in a combination of equity, debt, and international mutual funds. This will give you the right mix of minimizing risk and rewarding return.

2. Align Investments with Your Risk Appetite:

Also, risk tolerance forms an important criteria while deciding your mutual fund selection. You have to decide which one suits your heart and pocket. Equities funds are highly in demand and are appropriate for risk-tolerant investors, whereas debt and balanced funds suit low-risk investors.

Example: For an investor who is quite young, a higher level of equities exposure could be taken, whereas a conservative debt fund is more apt for an older person.

3. Select Funds with High Credit Rating
Select debt funds that have invested into high-quality securities with good credit ratings. The result will be less likelihood of default, and then credit risk will be lowered.
Example: More stability can be expected by choosing those funds that invest in government bonds or AAA-rated corporate bonds.
4. Stick to the Long-Term Investing
Mutual fund equity funds are rather long-term performers. You can ride through the ups and downs of the market, and reap the benefits of compounding over time.

Example: Instead of taking out your investments in a downward market, SIPs help you effectively average the cost of purchases as your investments keep getting invested consistently.

5. Periodic Portfolio Monitoring and Rebalancing
While rebalancing may at some times incur extra costs, it should be done time to time in accord with your investment objectives and can to some extent reflect your level of risk. The need is always for you to have your portfolio bring about consistency between your goals and the state of the market.

For example If there is a heavy boost in performance in your equity fund, you could rebalance by moving some of the profits to safer debt funds.

Conclusion

One of the greatest investment tools available for novice and seasoned investors alike is mutual funds. The knowledge of risk will help investors maximize returns while averting the pitfalls from making mistakes in mutual funds investments. Maintaining diversified portfolios, proper alignment of investments based on acceptable levels of risk, and knowledge about the market conditions can reduce these risks and result in sound decisions for investments.

Disclaimer:

All above recommendations are of the market analysts. Neither the author, nor the brokerage firm, nor Stockstoday.in will be responsible for any loss arising out of any such decision taken based upon this information. All users are cautioned to take their own expert advice prior to making any investment decision.