Understanding the Risks in Your Mutual Fund Investments

A mutual fund can combine your funds with other investors and have a professional handle the fund. They are in the form of bonds, stocks, and equity. As of FY24, the mutual fund industry in India saw significant growth. The total inflows through Systematic Investment Plans (SIPs) reached a record ₹2 trillion, marking a 28% increase compared to the previous fiscal year. However, you should know the hazards associated with investing in mutual funds.

Why is Investing in Mutual Funds risky?

As mutual funds engage in a wide range of financial assets, including debt, equities, corporate bonds, and government-backed securities (or financial instruments), the risk is there regarding mutual funds.

Numerous factors influence the price of these instruments and have a greater likelihood of losing money than making them. You will almost certainly see losses mounting if you don't stay invested. Therefore, it is crucial to determine the risk profile and invest in the best fund.

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What are the Risks of Investing in Mutual Funds?

The risks associated with Mutual Funds are as follows:

Volatility Risk

An equities mutual fund's investment value drops if the entire market experiences a downturn. They are also known as Systematic risks. A variety of factors impact any security market. Important variables include natural catastrophes, fluctuating interest rates, inflation, recession, conflicts, political unrest, shifting population demographics, and geopolitical concerns.

Liquidity Risk

Depending on the volume of transactions in the market, liquidity risk is the ease with which you can sell an asset or close to its fair value. Another type of liquidity risk was encountered by Exchange Traded Funds (ETF). After their issuance, ETFs are traded on the stock exchange. Finding prospective buyers or sellers of the ETF on the stock exchange is frequently challenging.

Interest Rate Risk

Changes in interest rates impact the price of a security. hedge funds Bond prices and interest rates go hand in hand. So, Bond prices decrease in response to a rise in interest rates. Similarly to this, bond prices rise when interest rates drop. As a result, changes in interest rates affect the financial instrument's value.

Currency Risk

Currency risk is the possibility of profits or losses resulting from changes in various currencies. Everyone is susceptible to the effects of currency risk, including governments, international corporations, and tourists traveling abroad.

Credit Risk

Based on several factors, the asset is rated by credit rating agencies. Bonds with high ratings pose less credit risk. Low-rate bonds also carry a high credit risk. There is a credit risk when the security issuer cannot pay the interest as promised. Debt funds that invest in bonds with weaker credit ratings run a higher risk.

Regulatory Risk

As the name implies, regulatory risk is a category dependent on government announcements and rules. The value of your investment will be impacted by any law or regulation that could harm the industry in which you have assets.

Concentration Risk

Concentration risk is the term for having significant exposure to one particular asset, industry, or theme. Concentrating a sizable portion of your investment on a single asset or asset type is not a good idea. Profits might be phenomenal if the market favors the collection of assets. If the tide for that particular item or combination of assets flips, there could also be substantial losses.

Inflation Risk

The danger of potential loss of your investment's buying power due to an overall rise in consumer prices is known as inflation rate risk or purchasing power risk. Fixed-income investments enable a clear understanding of inflation risk. The nominal return on your investment is if you purchase a bond with a 3% coupon rate. However, if inflation is 2%, your actual increase in purchasing power is only 1%.

Management Risk

Any mutual fund's performance depends on the manager's experience, knowledge, skill, and investment techniques/process. If any of these factors are lacking, the fund's performance will suffer, which will be bad for unit holders.

Rebalancing Risk

Mutual fund investments are regularly rebalanced and reviewed by the fund managers. On the other side, frequent reinvestments risk missing out on opportunities for investment growth. Additionally, periodic rebalancing will raise the management fees for the fund.

High-risk mutual funds

These are investment vehicles that aim for higher returns by investing in assets with greater volatility. These funds focus on sectors like technology, emerging markets, or small-cap companies. The potential for high returns is accompanied by a higher chance of significant losses, making them suitable for investors with a high-risk tolerance and a long investment horizon.

Key characteristics

These funds focus on companies that have strong growth potential. The returns can be substantial, but the risks are also high.
These funds focus on specific industries like technology, healthcare, or energy, which experience significant swings based on market conditions.
Investing in developing countries can offer high returns, but political instability, currency fluctuations, and less regulatory oversight add to the risk.
Small-cap companies may grow faster than larger firms, but they are also more vulnerable to economic downturns, making these funds riskier.

High risk mutual fund examples

Nippon India Small Cap Fund
HDFC Small Cap Fund
Edelweiss Mid Cap Fund
Kotak Small Cap Fund
DSP Small Cap Fund

Low-risk mutual funds

These are for investors who prioritize capital preservation and stable returns over higher potential gains. These funds focus on investments that have lower volatility and are generally considered safer, making them suitable for conservative investors or those nearing retirement.

Key characteristics

These funds invest in high-quality debt securities. They aim to provide a stable value and liquidity, with returns slightly higher than a regular savings account.
These funds invest in government-issued securities. They are considered low-risk because they are backed by the government, making them less likely to default.
These funds invest in bonds with shorter maturities and are less sensitive to interest rate fluctuations.
These funds invest in bonds issued by companies with strong credit ratings. While they carry slightly more risk than government bonds, they offer higher returns with relatively low risk.

Low risk mutual fund examples

Quant Multi Asset Fund
ICICI Prudential Equity & Debt Fund
Edelweiss Aggressive Hybrid Fund
Mirae Asset Aggressive Hybrid Fund
Canara Robeco Equity Hybrid Fund

What are the Ways to Overcome Mutual Fund Risks?

The best possible ways to overcome Mutual Fund Risks are as follows:

Recognize your level of risk tolerance so that you may make investments based on the optimum risk-return trade-off for reducing investment risk.
Keep enough liquid assets in your portfolio. Liquid and Overnight Funds, two low-risk investment options, should be available in our accounts.
Invest in various asset types, such as equity, debt, mutual funds, real estate, gold, etc., and have an asset allocation strategy.
It would be best to have fund managers with extensive experience to help you make investment decisions.
Portfolio diversification to lower total investment risk.
You must routinely monitor the performance of your portfolio and conduct cyclical reviews.
Invest in a blue-chip stock or fund to reduce liquidity risk.

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Final Thoughts

Each kind of mutual fund has a unique risk and return potential profile. It's critical to comprehend these risks and potential rewards before investing in a mutual fund.