Risks Associated with Mutual Fund Investing
“Mutual fund investment is subject to market risk” –we always hear this phrase whenever we talk about mutual funds, isn’t it?
In this chapter, we will take a look at the risks associated with mutual fund investing.
Why is mutual fund investment risky?
In a mutual fund, investment is made in various financial instruments – equity, debt, corporate bonds, government bonds, commodities, etc. As we know, the price of these products rises and falls, being affected by a lot of factors.
This price fluctuation is the reason why the NAV of every fund changes daily, and this is what imparts risk to mutual funds.
Risk Involved in Mutual Funds:
There are primarily six risks associated with mutual funds:
1. Volatility Risk
Equity mutual funds invest in shares of companies that are listed in the stock exchanges. As we know, the price of securities fluctuates in the market and is affected by macro and micro-economic factors.
As the value of shares goes up and down, the NAV of mutual fund schemes also changes – which is commonly known as volatility risk.
2. Interest Rate Risk
The interest rate on fixed income instruments (bonds, fixed deposits, etc) keeps changing as per rate announcements of the Reserve Bank of India. This is another risk associated with mutual fund investments.
Let us suppose that the interest rate of 10-year government bonds is 5% today. So, a fund manager includes these within the portfolio of a guilt mutual fund scheme and invests a substantial amount in them. So, the fund gets locked in for 10-years. But, after 6 months, the interest rate on 10-year government bonds increases to 5.5%. So, naturally , they become more lucrative than the bonds issued earlier. But since the fund invested by the fund manager is in a lock-in, the fund manager has no way of taking it out and investing in the 5.5% bonds. This is the risk.
Of course, this is an overly simplified example. The situation, in reality, is more complex since bonds are traded in the secondary bond market.
3. Concentration Risk
This is a very common risk where the fund manager puts most of the money in one kind of financial instrument or one sector. For example, if the banking and financial services industry performs well, a fund manager may put a large chunk into that sector. However, if tomorrow, due to some event, the banking sector starts performing poorly, the entire portfolio may go into a loss.
This risk is commonly faced by sectoral funds. One way to avoid this risk is to invest in diversified funds.
4. Credit Risk
This risk is very commonly faced by debt mutual funds. This happens when the issuer of a particular instrument fails to pay the promised interest or return the principal on time. This is why fund managers always concentrate on bonds with high credit ratings or those issued by the government.
5. Inflation Risk
Inflation is synonymous with purchasing power. You make money only if the return on your investments is more than the inflation rate. On the other hand, if it fails to do so, in reality, you lose money. This is known as inflation risk.
As of August 2021, the retail inflation rate of India is 5.3%. Therefore, if your portfolio is growing at a rate lower than 5.3%, then you are losing money.
6. Liquidity Risk
This risk is the difficulty faced by you while redeeming your investments at the time of need. It can come in various forms. Your portfolio may be at a loss when you need to redeem your funds. Alternatively, it may be in a lock-in fund, and cannot be redeemed no matter whether they are in profit or loss.