Finance

Risks you must be aware of before investing in a mutual fund

No matter where you decide to invest your savings, you should keep in mind that most investment products carry some amount of risk. And so do mutual funds. But that doesn’t mean you should avoid investing in them. In fact, taking a little bit of risk is the key to building a wealthy empire, you just need to understand the risks and how you can deal with those effectively. The risk in mutual fund investments largely refers to the probability of earnings being lesser from what was originally expected. To simplify, risk indicates the unpredictability of returns. Higher the return higher would be the risk associated with the investment. When you invest in mutual funds, the asset management company, in turn, invests your money in securities in various financial markets including stocks and bonds.

Here are some of the risks that mutual funds are subject to which every investor should be aware of:

Risk from market volatility

“Mutual funds are subject to market risks, please read the offer document carefully before investing”. No mutual fund television commercial in India is complete without the famous line being narrated. That’s true because the market is volatile and there is a risk of you losing money in case the market fails to live up to its expectations. Just like economic growth, political stability and other positive factors result in the growth of capital invested in the market, there are some factors that affect the market negatively. These include natural calamities, inflation, political upheaval or even geo-political tensions. Any development adversely affecting the underlying stocks can result in your funds to decline. While no market segment is unaffected from positive and negative factors, equity investments are more prone to market risks. However, this risk can be dealt with by staying invested for a longer term.

Inflation and Interest Rate Risks

High inflation and high interest rates can also affect the returns that you earn from mutual funds. Inflation eats into your real returns from an investment. A real return is the net of your return on investment and prevalent inflation rate during the investment period. The other factor is rising or high interest rates. This can be detrimental to your investments mainly in the debt category. This is because bond prices and interest rates typically move in opposite directions. Which could lead to a lower than expected return from your debt mutual funds when the interest rates go up. Moreover, high inflation also usually is followed by high interest rates, hence affecting the returns.

Credit Risk

Debt funds invest money on your behalf in bonds issued by various companies. All these companies do not have the same financial health and business potential. Similarly, these companies also have a varying degree of risk associated with the bonds they issue. So the market demands higher return (interest) from companies that have a higher risk. If all goes well, this investment could give a high return. However, there is also a possibility of some bond-issuing company not being able to repay the interest, or principal or both in time. This risk is called credit risk. Having said this, one should keep in mind that securities with higher risks tend to give higher returns as well.

Concentration Risk

Concentration in having your focus on one particular thing. In investments, concentrating a large chunk of your investment in one particular category of investments is not a good idea. It is a classic case of putting all, or most, of your eggs in the same basket. If the basket is hit, all eggs go waste. When we talk of mutual funds, there are categories of mutual funds that focus on particular sectors. Such schemes perform very well when that sector is doing well. However, when the sectoral performance declines, it affects your investments too. Hence, it is better to minimize this risk by spreading your portfolio across sectors, schemes and categories. That way you have a more diversified mutual fund portfolio and chances of you hitting rock-bottom reduce significantly.

You can deal with these risks

While it is necessary to keep a close eye on the risks that come with mutual fund investments, you should keep in mind that all risks are not associated with all types of mutual funds. For instance, while the market risk is largely applicable to equity oriented funds, credit risk is something that shadows the debt oriented funds. We highly recommend that you choose wisely, consult your financial advisor and maintain an asset allocation that is in line with your financial goals.

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