Mutual Funds

Mutual Fund and its Associated Risks

There is a famous saying “There is no reward without risk” However there is also a saying “Higher the climb, harder the fall”. That is all an investor needs to understand that risk should be analyzed well before investing in any mutual fund, whether its equity or debt. To understand better what types of risk are involved in different mutual funds here are different risks associated with mutual fund investing.

Market Risk

Firstly we will start with the most common and most severe risk which is market risk.

Market risk is the risk that is affected because of the changes in variables of the market. Every investment plan is subjected to market risk as investors earn when the company makes a profit and with that, the stock prices go up. As we very well know that different company units are bought in mutual fund investing market risk can directly affect your gain or loss.

There are various variables that affect the market and they are divided into external and internal factors. External variables like change in government regulations or SEBI guidelines for any particular stock and internal variables like micro-changes in policies in any company or labor strike in a company can affect the stock prices of the company invested. These contingencies which can cause loss to the investor are known as market risk or volatility risk.

There are 3 major types of market risk:

1. Interest Rate Risk

The interest rate risk is associated with debt mutual funds as when the interest rate of a bond fluctuates it affects the value of the bond.

2. Commodity Price Risk

The change in commodity prices like oil can affect the market. These kinds of risks affect both Equity and debt mutual funds.

3. Equity Price Risk

This risk is associated with equity mutual funds as changes in prices of the stock affect the returns of the investor.

Market risk is also known as systematic risk as it affects the whole industry and it cannot be eliminated through diversification as any natural calamity, terrorist attack influences the entire market. The effects of the COVID-19 pandemic cannot be hedged from systematic investing as all the industries are affected due to one factor.

Let’s jump to the risk which a consumer is dealing with daily and it plays a huge role in the life of the investor as well it is called inflation risk.

Inflation Risk

Inflation risk is also called purchasing power risk as a sudden rise in prices of goods and services we consume will affect the purchasing power of money.

Let’s take an example to understand it in a better way. For example Today an investor can buy a smartphone for Rs.10,000. Here we have calculated how much a consumer will pay for the same smartphone in the future assuming a current inflation rate of 5.5%. In March 2021.

 In 5 years₹13,070.00
 In 10 years₹17,081.00
 In 20 years₹29,178.00
 In 30 years₹49,840.00

Hence if the investor has earned at the rate of return of 5%, due to rising inflation the investor is at a loss. The investor has to take the inflation rate while investing as it affects the investor’s daily expenditure.

Credit Risk

The second risk is the credit risk which is involved in debt mutual funds. Credit risk is the risk an investor poses while investing in any debt instrument like bonds as there can be a delay or default risk of the issuer not repaying the principal and interest.

Credit risk is segregated into three types:

1. Credit Default Risk

Credit default risk is the risk that arises when the debtor is unable to pay its loan obligations in full or in any partial manner. Credit default risk is the most common risk in debt mutual funds and with the help of credit rating the company can manage its risk by investing in well-reputed companies which comprise the low risk. For example, a government bond consists of low credit risk.

2. Concentration Risk

Concentration risk is the risk an investor faces when it is associated with any single exposure in the market for example industry concentration. In industry concentration, the investor buys all the stock units from the same industry and will severely face a loss if that industry is affected.

3. Country Risk

Country risk is the risk of investing or borrowing from any particular country and any political, economical or technological change leads to loss of the investor.

Liquidity Risk

Liquidity risk arises when the investor is unable to redeem the funds without incurring any loss. In mutual funds, the equity-linked funds (ELSS) face this risk as due to the lock-in period they cannot be redeemed at the desired rate of the investor. Even exchange-traded funds(ETFs) get affected by this risk as there can be fewer buyers in the time of need.

Combating risk with different strategies:

Warren Buffet, Chairman and CEO of Berkshire Hathaway has recently quoted that picking stock is going to be difficult because it’s not that easy as it sounds. However, the risk can be analyzed and calculated for a better investment. The below image shows how the risk can be minimized:

Combating mutual fund risk with different strategies
There are some ways through which risks can be cushioned which are:
  • The investors should build the portfolio according to thier risk appetite which can be done by analysing the characteristics of investors like age of the investor, financial goals in an effective manner.
  • The investors can also cushion the risk through diversification, investing in hedge funds and investment through SIP.
  • Tarakki offers 3500+ mutual funds to invest in along with a riskometer with which an investor can measure his risk appetite and take mutual fund investment decisions accordingly.

Conclusion

It is important to know that every financial instrument has risk associated. However, there are ways to mitigate the risk with smart investment strategies.

Towards Prosperity

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