Risks associated with Mutual Funds
4 months ago
You must have heard the line which is accompanied by the advertisement of mutual funds- “Mutual funds are subject to market risk please read the scheme related document carefully”.
Have you ever thought about what the risks are? Well, I would say you haven’t that’s why you landed on this page. Now, when you are thinking to invest your money in mutual funds you need to know about the risks associated with it. These risks are often ignored by the investors but a rational investor is the one who compares the returns with the risks associated with mutual funds investment and then takes the decision.
In this article, a little step is taken in this direction to make you aware of the risks that are associated with mutual funds schemes. Before discussing the risks, we will start with the meaning of mutual funds and then we will discuss the risk associated with it.
What are mutual funds?
Typically saying, a mutual fund is a pool of money created with the contribution of different investors and managed by a fund manager. The contributed money is invested in different securities such as stock, bonds, gold, etc. Basically, it provides a gateway to enter into the share market with diversified risk and less cost.
Let’s understand with an example-
There are three persons A, B and C. all of them want to invest in share market but facing the following problems:
- Have only 200 rupees to invest but the share is of Rs. 1000
- Do not have knowledge about the financial market
- Afraid of volatility of market.
Here comes the role of mutual funds. With mutual funds, all given problems can be solved. The money will be collected from A, B, and C and the investment will be made in securities and units will be provided to them according to their contribution. Thus, A can have units according to his investment, B can avail the benefit of professional management of its funds by the fund manager and C can diversify its risk and can enjoy investing in the share market.
Also, there are some myths related to Mutual funds investment. Read the article to know more
Now let’s know about some of the major risk associated with mutual funds:
It is a well-known fact that mutual fund diversifies its risk by investing in different securities. But what diversification of risk will take place when the entire market is performing poorly. Market risk also known as systematic risk is an avoidable risk. There is a number of factors that can affect the performance of market such as inflation, political interest, recession, etc.
In some mutual funds scheme where the investment is majorly concentrated on a particular sector leads to concentration risk. If the portfolio is just dependent on the performance of only one sector then it involves a high risk of losing money due to the bad performance of that particular sector. It is always advised to have a diversified portfolio.
Interest rate risk
One of the risks associated with mutual funds is Interest rate risk. There is an inverse relationship between the interest rate and the value of debt securities. In other words, when interest rates go up the price of bonds goes down and vice versa. The change in interest rate depends upon the demand of the borrower and supply of credit by the lender.
Liquidity risk is also a major risk that is associated with a mutual fund. Liquidity risk refers to the risk when the investor is not able to sell or redeem its investment without incurring a loss in value of the investment. For example the lock-in period of ELSS which result in liquidity risk.
In very simple words, credit risk refers to the risk associated with the default on debt which arises on non- payment by the issuer of the scheme. Debt mutual funds suffer from credit risk. There are many credit agencies such as ICRA (Investment Information and Credit Rating Agency of India Limited), CRISIL (Credit Rating Information Services of India Limited), etc. which provide rating to the companies based on their creditworthiness. Companies with higher ratings provide higher interest rates to compensate for the credit risk associated with them. Sometimes fund managers get higher returns, invest in these low rating funds which expose investors to credit rate risk.
Inflation risk is one of the risks associated with mutual funds is refers to the decline in one’s real purchasing power. The risk arises when the investment return fails to provide a real return to the investors means the rate of return from investment is less than the inflation rate. This type of risk is mainly associated with investment having a fixed rate of return.
Currency risk is the risk of depreciation of the currency which negatively affects one’s investment value. In other words, currency risk is the possibility of a decline in the exchange rate which may lead to a decrease in your profit. The currency risk is also known as exchange rate risk.
It can be concluded that there are many risks that are associated with mutual funds. But there are many investment techniques that are used by the fund managers nowadays to mitigate the risk. You just need to be a little careful and make an effective and efficient decision by taking into consideration the various mutual funds risks.