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Know The 5 Vital Risk Involved In Mutual Funds - Outside View by PersonalFN

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Know The 5 Vital Risk Involved In Mutual Funds
Aug 29, 2017

Life is all about risks. Every path you choose, every decision you make involves a degree of risk.

Walk down your memory lane, introspect...and you'll realise that some of the decisions you took were sensible, and others senseless. Some may have worked in the interest of your financial wellbeing viz. buying your own house, planning for your children's future, your own retirement, while some others such as buying things you don't need, getting low quality white goods, etc. were absolutely pointless.

There's a risk involved when investing too, and hence you ought to make prudent decisions after you've recognised the risk involved, especially when you're opting for mutual funds as an avenue for wealth creation.

Mutual fund schemes invest in a variety of securities and the risk depends on the underlying assets (equity, debt, gold, REITs, InVTs) and securities it carries in its portfolio. As the market fluctuates, the value of stocks and bonds also move in a direction. This movement is reflected in the Net Asset Value (NAV) of a respective mutual fund scheme.

Your investments might generate returns as per your expectations, or it might not. This connotes the 'risk' involved. There are various factors which result into any kind of risk. Let's take you through different important types of risk while investing in mutual funds that you should be aware of. As follows:

  1. Credit Risk

    Suppose you lend some money to your friend for a period of 1 month. And after a month he/she fails to return your money. This is called as credit risk.

    Likewise, when you invest in a debt fund, there is a risk that the bond issuer may default. Therefore, investing in debt funds is not safe. You need to do thorough research, study the portfolio characteristics to assess the quality of debt instrument held by a debt mutual fund scheme. Ensure that the debt fund invests in highly graded / rated securities, because a company may default on its debt obligations.

  2. Interest Rate Risk

    As a naive investor, the interest rate fluctuations might have not bothered you. At the most, you might have paid heed while investing in fixed deposits or if you have a home-loan.

    But when you invest in debt mutual fund schemes, remember interest rates and bond prices are inversely related. Meaning, when interest rates fall, the value of bond prices rise (and so does the NAV of a debt mutual fund scheme) and vice versa. Hence, the value of your debt fund will appreciate/depreciate with the rise and fall in interest rates.

    Hence, be cognisant of the interest rate cycle the economy is in before investing in debt mutual funds and select the category of funds carefully.

  3. Liquidity Risk

    Liquidity risk arises when you are unable to sell your asset at a desired price at any given point. In other words, it arises when it is difficult to liquidate your assets/holdings.

    In such scenarios, fund managers are obliged to continue holding their position, and at times, it may even result in them selling these at much lower price which results in a loss.

  4. Price Risk

    This is especially pertinent to equity investing. Equity markets in short-term can be highly volatile. Noted economist, John Maynard Keynes has aptly articulated: "The market can remain irrational longer than you can remain solvent."

    Hence, it becomes vital to look at the price risk, because it can move in any direction. This price risk can affect the NAV of your fund, while volatility is integral to equity and equity related securities.

    But when you invest in equity mutual fund schemes, invest for long-term, and so short-term volatility or price changes will not deter you. Having said, that, you ought to prudently select mutual fund schemes, and past performance should not be the only parameter to consider, as this trend may or may not continue. A holistic evaluation is necessary to select winning mutual fund schemes after considering a variety of facets.

    If you need superlative guidance to invest in the best equity mutual fund schemes, opt for PersonalFN's unbiased and independent research service, FundSelect. We will share with you the 6 Ultimate Secrets to Beating the Market by a Whopping 70%! We strongly recommend you take advantage of this service.

  5. Macroeconomic Risk

    Besides the risk we discussed above, mutual funds, in general, are also exposed to macroeconomic risk. Macroeconomic factors such as growth, corporate earnings, inflation, interest rates, etc. do affect the overall value of the securities of a mutual fund scheme. So, when the economy at large is in good light, the positivity will also reflect upon the mutual fund schemes, and when it is not in good shape, that will have a bearing on the NAV too.

    As mentioned before, you ought to select mutual fund schemes carefully for your investment portfolio, so as to leave you with only the winning mutual fund schemes for your portfolio. To distinguish the wheat from the chaff, carefully analyse the consistent performers.

To Sum-up...

Though there are numerous risks involved in mutual fund investing, it should not be the only deciding factor. Always compare returns to risk for more meaningful analysis. Further, have a holistic view on the funds and take appropriate measures recognising your risk profile, investment objectives, financial goals, asset allocation, and diversify your portfolio wisely in a way that adds tax efficiency for your investment portfolio.

Be a responsible investor, HAPPY INVESTING!

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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