What is the risk of investing in Mutual Funds?
You would have heard this sentence probably 1000 times before and yes, you have heard it right. Like every other investment, mutual fund investments are subject to risks. This is because there is no way to predict what will happen in the future; whether given asset class will increase or decrease in value. This is applicable to all asset classes. But then you would ask why only mutual fund ads carry this disclaimer and why not fixed deposit or gold or real estate ads? Does it mean other investment options are safer than mutual fund? What are the risks of investing in mutual fund? Is there any way of mitigating them?
As I said, all asset classes are subject to market risks and mutual fund is nothing but an investment vehicle which invests in different asset classes; primarily equities and bonds. Each asset class has different type of risks associated with them and generally; higher the risk, higher is return! Equity asset class has higher market risks but lower interest rate risks than bonds. Quantum of risk is often dependent on holding period of asset class. In case of equity, higher the holding period, lesser is market risk. Let’s learn about type of risks one by one and try to find out ways of mitigating them.
Market Risks – There are many factors that affect markets. Economy, political situations, natural disasters and pandemics! we’ve seen how COVID-19 impacted markets. Market risks affect all asset classes, but impact is usually higher in equities as equity investments especially in shorter time-frame are often sentiment driven! the sole thing that an investor can neutralize market risk situations is to attend for things to fall in situ and stay invested for a decided horizon instead of redeeming in panic. Economies everywhere the planet have always recovered from recessions and even depressions within the past!
Liquidity Risks – Liquidity risk may be a risk related to ability of shopping for and selling investment especially in declining markets. Equities and bonds (and so open-end fund which predominantly invest in equities and bonds) are superior asset classes than land and gold in terms of liquidity risks. Lock-in period for a open-end fund scheme may end in liquidity risk as units can’t be sold in lock-in period; so be watchful of it!
Credit Risks – Credit risks are specific to bonds and occur when issuer of bond is unable to pay what was promised as interest. Any open-end fund investing fettered suffer from credit risks; degree of this risk however varies from scheme to scheme and may be gauged from credit ratings of the portfolio. Each bond in open-end fund scheme portfolio has rating. Fund manager tries to incorporate only high rated bonds but sometimes it’d happen that to earn higher returns; the fund manager may include lower rated bonds. Thumb rule of upper risk higher returns also applies to individual bonds and it’s an honest practise to align your return expectations to associated risks by watching credit ratings.
Interest Rate Risks – rate of interest risks are risks related to changes in interest rates. Interest rates impact all asset classes, but risk is highest fettered especially in future bonds. When interest rates rise, price of existing bonds fall as new bonds with higher interest rates become more attractive. Fund managers and investors attempt to sell them and costs of these decrease. Only thanks to reduce rate of interest risk is to diversify bond open-end fund portfolio by investing fettered of various durations.