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What are the Risks Involved in Mutual Funds?

What are the Risks Involved in Mutual Funds?

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Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.

“Mutual fund investments are subject to market risks; read all scheme-related documents carefully…” Are you concerned about this statement that warns you against risk in mutual funds? If you want to know more about the risk and investments, here’s a fact. 

All investments carry a certain level of risk. Does that sound relieving? There are a lot of ways risks impact our investment returns. 

But before that, let’s understand these risks, learn how to manage them and be an informed investor. 

Are there risks involved in mutual fund investments?

Yes, there are risks involved in mutual fund investments. 

Then, why should you invest in them? Why not invest in assets which have no risk at all? 

The answer is twofold. 

Firstly, there is no such thing as a zero-risk investment; secondly, over extended periods, the risk involved in mutual fund investments can be offset by the reward they can offer. 

Not quite convinced? 

Let’s go over this step by step:

  • Understand the risks involved in investing in general. 
  • Learn the relationship between risk and potential reward. 
  • Check the three major types of mutual funds.
  • See if there are any disadvantages of mutual funds.
  • Look at the risks involved in mutual fund investing in particular. 

Do all investments carry some level of risk?

There is no investment which carries zero risk. Even bank fixed deposits, considered safe in the investment world, have little risk. The risk is that of your bank going out of business or being unable to pay your principal and interest back to you. 

Your bank fixed deposits yield a positive return over short, medium and long periods with minimal risk. 

Now, doesn’t that seem like a significant investment with minimal risk? Looks very safe, doesn’t it? Is there a catch, though? What could go wrong with an investment carrying minimal risk? 

Let's find out.

Can less risky assets provide inflation-beating returns?

You might be taking a risk by not taking a risk too. This is especially true if you have a high-risk appetite. With the least amount of investment risk, you stand the risk of not being able to meet your goals. 

The prices of goods and services keep increasing every year. This is due to inflation. The inflation rate is the rate at which prices rise.

The returns from bank fixed deposits may not match the rate of inflation. So, even if you stay invested in them with all your money over long periods, the prices of goods and services in the market may increase more than the returns from the fixed deposits. 

So, safe or less risky investments also carry inflation risk. The risk involved here is that you may not be able to meet your financial goals with them even after long periods of investing.

Therefore, it is important to diversify your investments across different risk segments. You can do this by investing in different types of investments like short-term and long-term deposits and mutual funds. Your Fi account enables you to do both, saving in deposits and investing. It helps you save for your goals by dividing them into Jars. Similarly, you can invest in your goals through mutual funds. 

Risk and potential reward go hand in hand  

Let's understand the relationship between risk and potential reward with an example. 

Raju is a budget wedding photographer. His friend Farhan is a wildlife photographer. Raju has a regular business, while Farhan only does photography when he visits a wildlife sanctuary. Who do you think gets paid more per shoot? 

Farhan gets paid more because he undertakes more hardships and carries more risk for a shoot. So, the more risk you are willing to take, the more your potential rewards.

However, Raju gets a stable income because many budget weddings happen most of the year. 

Similarly, in the world of investments, less risky investments offer stable rewards, and more risky investments have a potential for inflation-beating rewards. 

Risk and potential rewards go hand in hand. 

Different risks one investment

Mutual funds are a type of investment that offers different types of funds that can match your risk profile and financial goals. 

Mutual funds which invest entirely in debt securities are low-risk funds. Low-risk debt funds only invest in AAA bonds and government securities. But not all debt funds are low-risk mutual funds.

There are a few debt funds that invest in AA corporate bonds also. These bonds have a lower credit rating and therefore can be riskier. There are also debt funds that invest a certain proportion of their underlying assets in equities. These debt funds have moderately low or even moderate risk. 

For the risk profile above moderate risk, there are funds that invest a major proportion of their investment into equities. 

Even in equity-based mutual funds, the degree of risk varies from one fund to another. For example, an index fund will have a lower risk profile than sectoral funds. 

The main difference between the two funds is diversification. An index fund simply mirrors the returns of an index. For example, a Nifty50 Index fund will have all the stocks in the Nifty50 index as its underlying asset. The index comprises stocks with different types of business. Therefore, with diversification, the risk decreases. 

Sectoral funds fall under the high-risk category because they focus on the performance of a single sector. The returns of the fund depend entirely on assets belonging to one particular sector. Therefore, these funds have a high degree of risk due to low diversification. 

To conclude

Mutual funds offer a plethora of schemes based on different risk profiles. To look for a scheme that matches your risk and goals, you can first look at your risk appetite and then the risk-taking capacity for your goal horizon. The Fi money app can help you start your SIP in a quick and simple manner. 

Also, saving for your goals through deposits is easier by creating Jars in your Fi account. These Jars enable you to segregate your saving goals and track your journey towards them. 
Check out this short video to learn more: https://www.youtube.com/shorts/sQwMeMKu3oY

Frequently asked questions

1. What are the disadvantages of investing in mutual funds?

There are no disadvantages to investing in mutual funds. However, you can turn your mutual fund investment into an advantage if you invest after knowing about your own risk profile and matching it with the risk profile of your chosen funds. 

Your choice of mutual funds can be based on factors like your risk appetite (age, income level, geographic location, number of dependants and more) and your goal horizon (short-term, medium-term and long-term). 

Do you find yourself searching for content revolving around “low-risk high return mutual funds in India”, "what is the risk in mutual fund investment? or “what are the risks in mutual funds?” or similar search phrases from time to time? The Fi money app offers research material with plenty of insights on investments, their performance, risk and potential returns. 

2. What are the three major types of mutual funds?

All mutual funds are not the same. They can be classified using a lot of methods. One method of classifying them is by the type of assets they invest in. Based on this method, the three major types of mutual funds are:

  • Equity
  • Debt
  • Hybrid

Equity mutual funds invest in equities. Debt mutual funds invest in debt securities in a high proportion. Hybrid mutual funds invest in both equities as well as debt assets. 

3. What are the risks in mutual funds?

Let's play a small game, shall we? See if you can complete the following sentence: 

Mutual fund investments are subject to __________ ________. 

Yes, you guessed right from that line in the advertisements for mutual funds. It’s market risk. That is the first risk on our list. 

Let’s look at the significant risks individually and ways to mitigate and manage each risk.

  • Market Risk

If the whole market undergoes a downswing, the investment value of an equity mutual fund also declines. This is market risk. Market risk is also known as systematic risk. 

There are a lot of factors that affect the market for any security. Significant factors are natural disasters, inflation, recession, political turmoil, varying interest rates, wars, changing population demographics and geopolitical issues. 

Two ways to manage this risk are diversification and long-term investing. 

  • Concentration Risk

Concentration means focusing a lot on one thing or a set of things and ignoring others. 

Concentrating a considerable amount of your investment in one particular asset or asset class is not a sound idea. For example, you may be tempted to invest in stocks from the financial sector only if you have had good returns from that sector in the past. 

Profits may be stellar if the tide favours the asset or set of assets. However, losses may also be huge if the tide for that one asset or set of assets turns. 

To minimise this risk, you can diversify your portfolio across assets, sectors and asset classes like investing in various stocks from the manufacturing, service, retail, and infrastructure sectors and investments in government-backed bonds and corporate bonds. 

Investing after seeking professional advice from a SEBI (Securities and Exchange Board of India) registered investment advisor can help you manage this risk. 

  • Interest Rate Risk

Interest rates vary depending on the market's demand and supply for credit. Interest rates and appreciation from securities held are generally inversely proportional. An increase in the interest rates may result in a lowering of the price of already bought securities.

This risk is more pertinent for the bond market. However, equity investments also carry this risk. 

You can manage this risk by investing in a diversified manner in mutual funds. 

  • Liquidity Risk

Suppose you wish to redeem your mutual fund investment, but they haven’t matured yet. This can happen with funds with a maturity period, like the Equity Linked Savings Scheme (ELSS). These funds have a maturity period of three years. 

With these funds, you can face liquidity risk. Liquidity risk is the risk of not being able to convert your mutual fund investments into cash in your bank account. 

A mutual fund that offers easy liquidity is liquid. This fund can be converted into cash in just one working day. This aspect of liquidity makes them suitable for goals like emergency planning.

  • Credit Risk

Credit risk is when the security issuer cannot pay the interest as committed. This risk is higher in debt funds that invest in bonds with lower credit ratings. 

With your Fi money account, you can invest across mutual fund classes. Also, saving for your goals is easier by creating Jars. These Jars can help you categorise your goals by naming them and stay committed to reaching them on time. 

4.Can I lose my invested money in mutual fund?

Mutual funds, like all investments, carry some level of risk. The value of the fund's holdings can go up or down in response to market conditions, and this can affect the value of your investment. Additionally, the fund's management fees and expenses may also reduce the overall return on the investment. However, it's important to note that diversifying your investment portfolio with different types of assets can help to manage risk and it is not unusual for mutual funds to have ups and downs, but over a long-term period they have the potential to provide a higher return than savings account or bonds.

5. Are mutual funds risky in long term?

Mutual funds, like all investments, carry some level of risk. However, the level of risk can vary depending on the type of mutual fund you invest in. In the long-term, mutual funds that invest in stocks have the potential to provide a higher return than those that invest in bonds or cash, but they also come with a higher level of risk.

It's important to note that diversifying your investment portfolio with different types of assets can help to manage risk. Additionally, investing in mutual funds for the long-term, such as several years or more, can help to smooth out the ups and downs of the market, and provide a better chance of earning a positive return on your investment.

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