Investing in mutual funds is not without risks. However this shouldn’t keep you from investing in them. The only prudent way to minimise such risks is to understand them and find ways to earn even in testing market conditions. Discussed here are the different types of risk associated mutual funds and how to combat them.
Risks involved in equity funds
- Volatility risk
Equity mutual funds typically invest in shares of companies listed on the stock exchanges. The value of these funds depends on the company’s performance, which may be impacted by changes in government regulations, RBI (Reserve Bank of India) policies, economic cycle, etc. These factors affect the stock prices and might lead to a rise or fall in share value and a subsequent change in the value of your mutual fund investments.
- Liquidity risk
Some mutual fund categories, like Equity-Linked Savings Scheme (ELSS), may have rigid or long-term lock-in periods. Owing to their long lock-in period, you may find it difficult to liquidate your investments without bearing a loss.
Risks involved in debt funds
- Interest risk
Interest rate risk is the possibility of a change in the value of the debt instrument due to unexpected fluctuations in the interest rate.
- Credit risk
Credit risk is when the scheme’s issuer cannot pay the assured interest.
- Inflation risk
Inflation risk is the risk of losing your purchasing power due to inflation. You may be affected by such risks when your investment fails to keep up with rising inflation.
Stepwise approach to managing your mutual fund risk
- Choose funds depending on your risk appetite
Your risk appetite fundamentally depends on your liquidity, income stability and the time frame of your financial goals as well as your individual risk taking propensity. For example, retail investors with long-term financial goals may be more comfortable selecting equity funds as equities hold the potential to earn handsome returns in the long run. While equities may be volatile in the short term, a longer investment time frames give equities more time to recoup losses due to market volatility.
Likewise, retail investors facing income uncertainties may need to invest in debt mutual funds for higher liquidity and capital preservation to meet periods of cash flow disruptions. As the risk in mutual fund schemes differs from one category to another, always factor in your risk tolerance level when selecting mutual funds.
- Go for the SIP option
The SIP route automatically deducts a predefined monthly, quarterly, or yearly amount to buy units in the selected mutual fund. As SIP investments are disseminated over time, investment costs are averaged during market corrections or dips. Continuing your SIP for a long period can help you make the most of market cycles. As SIP installments are automatically debited, it helps teach financial discipline and removes the need for market timing.
In the case of debt investment through SIP, you can invest for the short term to meet your crucial short-term goals. Debt funds are best for the short term as they offer higher capital protection and liquidity to meet your goals spanning up to three years.
- Diversify your investment portfolio
Many individuals invest their entire surplus in one or two mutual funds that have generated the best returns in the past. Doing this concentrates the market risk. If the selected schemes perform poorly, the investment portfolio underperforms broader markets for an extended period.
Thus, ensure you diversify your mutual fund investments across different fund houses. Doing so can reduce concentration risk in mutual fund schemes that are added to your portfolio. If any of the funds in your portfolio performs poorly, other funds might generate adequate returns to compensate for the losses.
Bottom line
Risk and reward go hand in hand. Higher risk usually means a higher reward. However, it is imperative first to define your risk appetite. Jumping into high-risk funds does not work if you are a risk-averse investor. Following the abovementioned strategies can help you manage your mutual fund risks.
