We usually think that Mutual Funds are not subject to market risks. Isn’t it? Well, there is a risk in everything we do. For instance, the car is at the risk of an accident, but that doesn’t mean that you will stop buying the car.
Similarly, when we talk about mutual fund investment they are also prone to a variety of risks.
But these risks shouldn’t deter you from investing the money. You have to be a smart investor.
What smart investors do? Smart Investor is the one who knows these risks and tries to mitigate those risks by applying various strategies.
We can definitely say that often knowledge about mutual funds is the best to hedge against any risk.
And most people lack in attaining the good knowledge. A good study will always help you in order to be a smart investor. Let’s us discuss some of the different kinds of risk that are associated with mutual funds.
Equity or Stock Market Risk with Mutual Funds
People mostly invest in equity mutual funds. Basically, investing in the stock of companies listed in the stock market.
Thus, equity mutual funds or any fund that has some amount of money invested in equities runs the risk associated with stock markets. It is the risk caused due to the volatile nature of the market where the prices of the stocks keep fluctuating due to various reasons.
These reasons could be external and internal.
External reasons affect the entire market, causing the value of stocks or securities to come down. For example: If there is a possibility of a country getting into a warlike situation, there is a widespread fear that this will impact the economy and the companies that are part of it.
Because of this fear, it is possible that prices are of all stocks or at least the majority of the stores in the market may witness a fall. Since, this is a fall for the entire stock market you can say, mutual funds that invest in stocks will also see a fall in their value.
This was the external reason, but when you talk about internal reasons, companies or any specific industry never affect the entire market.
For instance, if the sales of a company’s product fall due to the arrival of a better product in the market. The price of the stock will fall and if the mutual fund you invest in has a dominant share of such a company then in its portfolio, you might be facing a loss in the future.
Therefore, some industry-specific internal factors do affect all the company belonging.
For example, there are new government policy changes with regard to the specific industry.
This risk is faced by all debt fund investors. Debt Mutual Funds invest in types of fixed-income instruments like debenture and bonds. The issuer of the instruments is the borrower, whereas the fund is the lender. When borrower borrows the money, they agree to repay the principal amount as well as pay the interest with an agreed schedule. But there are limited possibilities that may happen in the management.
- The borrower fulfills commitments in time
- The borrower successfully pays the due but with delay
- The borrower defaults i.e. they don’t pay the principal amount
The first situation still seems desirable and it happens most of the time. There is the possibility that the other two situations might happen. Hence, the credit risk is the occurrence of the second and third situations.
Debt Funds that lend to stable companies have lower credit risk. There are funds that seek bonds that have a low credit rating that aims to generate higher returns for investors. Also, when it comes to credit risk, funds that invest in bonds only issued by the government are the interest.
Also, when it comes to credit risk, funds that invest in bonds only issued by the government are the safest.
Interest Rate Risk
Interest Rate Risk is associated with debt funds. Just like stocks, bonds are also traded and their prices are highly charged. This change in bond price share shows an inverse relationship. So, when the interest rate in the economy increases, the prices of existing bonds decrease since they continue to offer at old interest rates.
Example: Assume a bond was issued at Rs 1000 for one year, and it is offered at the interest rate of 7%. Immediately after the bond is issued, the interest rate increased and new bonds are now offering 7.5% interest. This decision has made the impact of the earlier bond less attracted and the demand of the same goes down.
Such movement results in bond prices on account of changes in the interest are referred to as interest rate risk. This is a market-wide factor affecting the prices of all bonds and eventually affecting the value of all debt mutual funds.
Inflation is the rise in the general level of prices of various goods and services that we use in our daily needs. It erodes the purchasing power of the money.
If inflation is not planned before you are making an investment plan then this could be a big risk. Hence, it becomes extremely necessary to make investments in avenues that will help you to protect your purchasing power or not.
Mutual Fund Investors are subject to market risk all the time. You cannot avoid the risk as these risks are not in your control and they can either be controlled by anyone. But what you can do is planning smartly for each and everything. It was bound to affect the markets, all you can do is manage the risk or mitigate it by conceiving different investment strategies.