Types of Risk Involved in Mutual Fund Investments (SIP & Lumpsum)
August 20183 min read
So What are Mutual Fund Risks?
“Mutual Fund Investments are subject to Market Risks. Please read all the fund related documents carefully” is the disclaimer we hear at the end of a Mutual Fund ad, being read by a squeaky voice in a wanton rush. Now they have slowed him down with every word deliberated slowly and clearly so as to pass on the message. But the intensity of this disclaimer can only be known when we invest our own funds and see the portfolio value going up and down.
A bad first experience with investments can affect your investment journey forever. One of the ways of dealing with risks involved in mutual funds is to get accustomed to the functionalities of mutual funds. This will help in managing the risk to our own advantage.
So this blog will dig dipper in the different types of risks in a mutual fund with the aim of providing a solution to reduce the risk, in turn, enhancing the returns.
Types of Risks Involved in Mutual Funds?
As mutual funds invest the money in capital markets (both equity & debt), the risks involved in capital markets get translated to the mutual funds also. Hence, let’s take a look at risks associated with capital markets:
Systematic Risk is essentially the risk which you cannot avoid.
Types of Systematic risk are embedded in equity and debt markets are different. Equity markets have market risk or as called in technical terms Beta. Equity investments tend to get volatile because of market risk.
Whereas, debt markets have interest rate risk exposure which is dependent on RBI’s repo rate movements. As the duration of the fund changes, exposure to interest rate risk changes. The basic principle of the interest rate risk is that bond price movement and interest rates are inversely proportional i.e. the bond price goes up when interest rates go down and vice versa.
Apart from these two systematic risks, an important factor which impacts investment is the inflation risk. Increasing inflation reduces the disposable income for investors, which in turn reduces the capability to invest.
So What is The Solution to This?
Although, Systematic risks cannot be avoided, they can be managed with appropriate Asset Allocation. Asset Allocation is essentially creating a portfolio with multiple assets. For example, you can create a portfolio with Indian Equity, Debt, International Equity and Gold.
Now in any given point in market, there will be one asset class which will outperform others. But at the same time, during volatility in market, one asset class will protect the portfolio from downfall.
Hence it is important to create a portfolio with multiple asset classes based on your need.
One of the best examples of Unsystematic risk can be taken from the recent news of IL&FS default and Jet airways shutting down its operations.
Financial risk is the risk where a company’s ability to service its debt obligations is affected. This is exactly what happened with IL&FS when it defaulted on interest payments to its lenders. Versus Business risk is a risk where an entire business faces issues in terms of driving revenue, high costs, economic climate, and increased competition. Because of these reasons, Jet Airways had to shut down its operations.
How Can We Deal with Unsystematic Risk?
These risks can be managed by diversifying the portfolio to ensure that there is exposure to multiple sectors. Now, does this mean that we have four – five funds from every category and call it diversification?
The answer is no.
Diversification means that the portfolio should be exposed to multiple sectors of multiple market capitalization which perform different in every market cycle. Hence if we are looking at equity funds, we would only need one or two funds from each category as per investor’s needs.
Same is the case with debt funds. Based on your investment horizon and risk appetite you can select a few funds and stay invested in them.
Understand these risks and understand your own risk appetite. This will help you to make long term mutual fund investments.