Risks associated with MF investments
You might have come across various mutual fund advertisements stating, “Mutual Fund investments are subject to market risks. Please read the offer document carefully before investing”. Most people tend to relate such risks to those involved in stock market investments as the disclaimer mentions “market risks”, but is that the only risk involved while investing in mutual funds? Apart from market risks, mutual funds are prone to several risks which are enlisted below.
Equity Mutual Fund Risks
1. Volatility Risk
Volatility is the extent to which the price of any asset fluctuates. Thus, more fluctuation results in high volatility and accordingly, high risk. In the short run, equity tends to be highly volatile, but in long-term, the volatility of equity reduces. Hence, investors first need to understand the purpose and horizon of their desired investment. This will assist in making better investment decisions.
2. Concentration Risk
When a mutual fund has high proportions devoted to a single company or a single stock or single instruments or even a single sector, then it is carrying concentration risk. A relevant example of such funds is thematic and sectoral funds. These funds are exposed to concentration risk as they are centred on one sector or theme. Even the focused equity mutual funds carry concentration risk as they invest in limited stocks, say 30 or 50. In this way, they have less scope for diversification.
Not just equity mutual funds, but even debt mutual funds are susceptible to concentration risk. Debt mutual funds investing high proportions in single debt instruments or in various debt instruments of a single company or of a same group of companies pose concentration risk.
Debt Mutual Fund Risks
1. Interest Rate Risk
Debt mutual funds primarily invest in fixed income securities. The value of these securities depends upon existing interest rates in the market. Inversely proportional as they are, as and when the interest rate in the market falls, the prices of the debt instruments rise and vice versa. In the short run, interest rates are relatively stable. However, in the long run interest rates have a tendency to be volatile.
2. Credit Risk
When the issuer of the debt instrument defaults payments or carries a probability of defaulting the payments, such debt instruments are prone to credit risk. Debt instruments with low rated papers usually are greatly inclined to credit risk. Most of the funds take credit risks in order to generate high returns. Therefore, it is worthwhile to check their credit ratings before investing in debt funds.
3. Inflation Risk
Inflation risk is one that constantly works silently in the background, and can be categorized as systematic risk as it is unavoidable. Yet, it can be reduced to some extent with a proper investment strategy in place. Inflation risk is nothing but the risk that reduces your purchasing power. Although we have characterized this risk under debt mutual funds, even equities are prone to this risk. However, historically, equity mutual funds have proven to be successful in beating the inflation. Relative to debt mutual funds which are usually more predisposed to inflation risk, equity has potential to overcome inflation.