Mutual Fund investments are subject to market risks, read all scheme related documents carefully.’ The warnings that we hear with the mutual fund advertisements are actually very much true. Most of the mutual fund investors tend to ignore this caution. But it is important that as a mutual fund investor, you are aware of the risks that you are taking. The risks of investing in mutual funds are mainly dependent on the securities the fund manager invests in.
The market risk referred to in the above statement are of two types:
- Systematic risk: It is that risk of which you cannot do anything to reduce it. It is the uncertainty in a security’s total returns that are directly associated with over-all movements in the general market or economy. Interest rates, recession and wars all are the sources of systematic risk because they affect the entire market and cannot be avoided through diversification.
- Non-systematic risk: It is that risk which can be reduced through diversification. This risk is unique to a particular security. The fund managers take care of this. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be an unsystematic risk.
Unsystematic risk can be categorized into these into the following types:
- Price risk: It is the risk associated with the volatility of the investments (stocks, commodities, debt, currency etc.). A security is said to be more volatile if its price changes a lot over the day in comparison to the others. This price change can sometimes help to make profits. Volatility is caused due to the certain events including those directly involving the companies whose securities are owned by the funds, general economic and market conditions, regional or global economic instability, or currency and interest rate fluctuations. This risk can be reduced by diversifying across companies and sectors.
- Interest rate risk: Interest Rate risk is associated with movements in interest rate, which depend on various factors such as government borrowing, inflation, economic performance etc. Schemes that have heavily invested in debt and bonds are affected directly by a change in interest rates. Equity and index oriented mutual funds are, however, not affected directly by increase or decrease in interest rates. Interest rates and return on debt are inversely proportional. So one gains in a falling interest rate scenario and vice versa.
- Liquidity risk: Liquidity risk is the risk associated with the marketability of an investment. It arises if a fund cannot quickly convert its investments into cash in a short period of time. Because of this risk, the mutual fund may, therefore, be forced to sell a security at a lower price, sell other securities in its portfolio or let go an investment opportunity due to liquidity constraints. This could have a negative effect on the fund’s performance. Usually, mutual funds investing in small-cap stocks face this risk.
- Credit risk: Mutual fund schemes invest in corporate debt and commercial papers of various companies. So there arises a credit risk of non-payment of the principle as well as the interest payments. Credit risk refers to the possibility that a particular bond issuer goes into financial problems and will not be able to make expected interest rate payments and/or principal repayment. Typically, the higher the credit risk, the higher the interest rate on the bond.
- Concentration risk: Concentration risk comes in when a mutual fund invests a large proportion of its money in a single stock or a particular sector. Sector funds, by definition, suffer from concentration risk because they invest in a single sector.
- Currency risk: Currency risk is that form of risk which arises from the change in the price of one currency against another. For example, if the mutual fund invests in debt or equity of some other country then you will face currency risk. If some of your US investments earn 10% in one year in dollar terms but the same year dollar loses 2% in comparison to rupee – your actual return will fall down to 8%.
- Reinvestment risk: This risk arises from uncertainty in the rate at which cash flows from an investment may be reinvested. This is because the bond will pay coupons, which will have to be reinvested. The rate at which the coupons will be reinvested will depend upon prevailing market rates at the time the coupons are received.
Now after knowing the risks that are associated with mutual funds what one can do about it is to be careful while investing in mutual funds. Make sure that you invest in a well-diversified mutual fund. Diversified mutual fund schemes help you avoid the concentration risk. And if you invest in sector-specific schemes or small/mid cap funds then make sure that you invest in them after properly knowing all the risks associated with them. The best way to reduce the risk to reduce the mistakes done while investing in mutual fund.
