I often come across advertisements for mutual funds from various fund houses and regulatory bodies, urging people to invest in this tool. But they always have a disclaimer in the end, which says that mutual funds are “subject to market risks and we should invest after considering all the factors.” However, very few know what these market risks are let alone understanding them.
I will very briefly touch upon these market risks so that my gentle readers are aware of them while investing in mutual funds.
Let us look at equity funds first. They involve primarily risk of capital loss, volatility and inflation.
Risk of capital loss happens when the principal invested loses value due to fluctuations in the markets. However this is a normal phenomenon and is rectified by staying put with ones investments until the principal returns back to the earlier levels, which is bound to happen sooner or later.
Risk of volatility is associated with vagaries of the market and is a part of the risk mentioned earlier. Your investment is subject to fluctuations of the capital markets and the price movements of the stocks, which the fund is holding in its portfolio.
Risk of inflation means when Inflation is eating away into your investments then your real returns are inflation adjusted. Let us say a fund has delivered 12 per cent return in a year however the rate of inflation in that year was five per cent hence it means that you have actually got a real return of only seven per cent, which is return minus rate of inflation.
All markets globally face what is called slowdown cyclical when the economy slows down. This happens at regular intervals and may affect your investments.
Risks associated with debt or income funds
Default risk happens when a bond, which is held in the scheme portfolio, defaults in its capital or interest payments and is downgraded in its ratings by the rating agencies. It can happen to even AAA rated bonds as was recently demonstrated by IL&FS and DHFL defaults both of which were AAA rated bonds. However, the situation was soon corrected by the companies which made the payments subsequently.
Interest rate risk happens due to fluctuations of the interest rates in the debt markets. If the rates rise then the bonds, which are held by the scheme, are discounted in the marked to market scenario and vice versa. There is also the re-investment risk where after the maturity of the bond the scheme may not get a good interest rate on re-deployment of its maturity proceeds.
Liquidity risk as the name suggests when a bond held by the scheme is unable to find a buyer in the market and has to be sold at a discount to meet the redemption commitments of the scheme.
Universal risks in equity and debt schemes
Geo-Political Risks are when there are natural calamities or even a warlike situation affecting the markets. The solution is to wait till the storm subsides.
Policy change risks: There at times may be a government policy change in a certain sector or affecting the markets as a whole, which may not be received positively by the markets and can result in the markets delivering poor results. Fund managers are always keeping an eye on these changes and will try to get out these sectors as soon as possible.
Concentration risks: Concentrating a considerable amount of one’s investment in one particular scheme or sector or theme is not a good option. Profits will be huge if lucky, but the losses will be more.
Best way to minimise this risk is by diversifying your portfolio. Concentrating and investing heavily in one sector is also very risky. The more diverse portfolio, the lesser the risk is.
Before concluding, I would like to reiterate that please understand the risks associated with your investment and talk to your financial advisor.
Remember that time is the best healer and with a longer duration in the markets and a longer investment horizon we can overcome most of these risks.
The author is a wealth advisor and Founder, Tangerine Ideas