Investments including the ones in mutual funds carry certain risks. Does that mean that you should stay away from them? No, the best way to handle the risk is identifying and understanding it and taking adequate steps to manage it and earn decent returns. Here we talk about mutual funds, one of the most popular investment options and the risks attached to them.
What Makes Mutual Funds Risky?
Mutual funds in India are risky because they invest funds in instruments like debt, equity, corporate bonds etc, the prices of which tend to fluctuate in response to several factors and situations. A decline in the value of investments made by the mutual funds results in a decline in the net asset value or NAV of the concerned scheme. This erosion in the value of investor money can be avoided by analysing the markets, the factors affecting the various instruments and planning and diversifying the investments.
Types of Investment Risk
The nature of risk involved in mutual fund investments depends on the type of instrument in which the fund is investing. While equity funds in India invest predominantly in equity and equity-related instruments and so are subject to market risk, debt funds investing in debt instruments carry the risk of changes in interest rates. Similarly, fixed-income instruments do not have a market risk while equity funds protect against inflation risk.
Some prominent risks associated with investments in mutual funds are:
- Market Risk or Volatility – Equity funds in India invest mainly in the company stocks whose prices are dependent on several factors like the company’s and industry’s performance besides policy issues. These factors may result in an increase or decrease in the price of a stock. A sharp decline in the prices of stocks or equities can erode the mutual fund NAV of your equity funds.
- Inflation Risk – High inflation levels can negate or reduce the returns derived from the gain in your mutual fund investments. Say if your mutual fund investment grows by 10% in a year and the cost of living rises by 4% during the same time, your real return stands at only 6%.
- Interest Rate Risk – A change in interest rates has a significant impact on the bond prices and the returns of the debt instruments. The interest rates and the bond prices have an inverse relationship which means that as the interest rates rise the price of existing bonds falls as they continue to offer the old interest rates. This interest rate risk varies for bonds with different maturities. While the bonds with longer maturities tend to witness higher price fluctuations, the ones with shorter maturities witness lesser fluctuations.
- Currency Risk – A decline in the exchange rate can reduce your gains or enhance your losses. This is important in the case of foreign currency-denominated funds. The changes in exchange rates may also impact the stock price movement of global companies or companies whose performance is highly dependent on the changes in the currency rates.
- Credit Risk – This refers to the risk of the bond or debt instrument issuer not having enough funds to make the interest payments or redeem the instruments on time. Such risk can be avoided by buying units of funds that invest in securities with high credit ratings or funds investing in bonds of government agencies.
While all these risks are related to external factors and you cannot control them, diversification of your investments is the best strategy to deal with them.
