As we have discussed so far, a Mutual Fund is a very robust and diversified investment vehicle that gives the investor access to multiple stocks, bonds and other securities while at the same time minimizing his/her risk.
However, the key point in that sentence is ‘minimizing’. MFs reduce your risk and exposure but they DO NOT eliminate it and that brings us to the crux this blog post. What are the risks associated with Mutual Funds that every investor needs to keep in mind. Let’s have a look at what these risks are and how they arise.
Equity is a major avenue where mutual funds invest in and all equity markets in the world are strongly influenced by macroeconomic drivers (highlighted below):
Currencies and Forex Rates
GDP Levels and Growth
Al these factors impact how a company performs which directly impacts how its stock performs. Hence, when investing in mutual funds, all these factors play a key role in the risk you take on as well as the return you generate for yourself. You have to always be prepared for unfavorable movements in any of thee macroeconomic indicators.
When investing in a range of stocks/bonds, there will definitely be a few securities in your portfolio that may not be that liquid. This makes it hard to buy/sell on these and can impact your returns on that fund.
The level of liquidity of course depends on the cap-size of your fund(larger cap funds are generally more liquid than smaller ones) but it helps to bear in mind that liquidity risk is a key aspect of MF investments.
Equity markets especially are highly volatile. And it is possible that you may have to face unexpected volatility from time to time.
This is what those mutual funds ads highlight when they mutual funds are subject to market risks. They really do mean it when the say ‘Please read all scheme related documents carefully before investing’
Interest Rate Risk
Jut as volatility can be a problem for equity markets, interest rate movements impact debt markets. It is an economic fact that bond prices and interest rates have an inverse relationship. In other words, when interest rates rise, bond prices tend to fall. And when bond prices fall, a MF invested in those bonds gets affected depending on your position on those bonds.
Hence, it helps to keep track of interest rates in the market so that you can safeguard yourself from this risk.
When you invest in MFs, you are investing in securities and each of the counter-party companies can default on their interest or principle payments. This is referred to as credit risk and it is a real factor that impacts your returns on that fund.
In Conclusion: Don’t freak out!
After reading all these risks, it may seem that Mutual Funds are very risky instruments and are not a feasible investment vehicle. That is not true.
I still stand by my word that MFs are robust and attractive.
You just need to understand that nothing in the world has zero risk and mutual funds are not an exception to this rule. The practical way to look at them is that while investing, be aware of the risks involved and prepare yourself so that you do not lose out on unfavorable market movements.
To understand these movements, I suggest start small. Begin investing with small amounts so that you get a clear idea of the risks involved and are able to effectively plan and hedge against them.