If your investment value falls by 25% from Rs 1,000 to Rs 750, it will need to go up by 33.33% to get back to the original value of Rs 1000.
Similarly, if it falls by 90%, it needs to go up by 900% to recover the original price. Thus, the importance of downside protection, which is possible if you manage your risks well.
While these numbers should not put you off investing in mutual funds, it is better to understand the underlying risks of investing in mutual funds to formulate a strategy and earn decent returns.
Different mutual fund categories are exposed to different kinds of risks depending on their investment objective and style. Within a category, the risk profile of different schemes belonging to that category varies too.
Witnessing the growing number of retail participation in mutual funds, Sebi has tried to make it easier for retail investors to understand the risk through a risk-o-meter.
However, it is imperative to look at the following major risks that mutual funds are exposed to before making your investment decision.Common Risks Associated With Equity & Debt Funds
Inflation is the biggest risk which eats up the returns generated by your investments in mutual funds. If your investments are not generating higher returns than the prevailing inflation rate, then you are just losing money from your investment.
Here’s some math. If you need Rs 10 lakh annually to take care of your living expenses today, you will need Rs 27.59 lakh to maintain the same lifestyle after 15 years. This is assuming a 7% inflation rate per year.
Investors must factor in the rising prices while investing for their goals. To achieve long-term goals, investors can consider equity funds.
These funds have the potential to beat inflation by a sizable margin and multiply investors’ wealth over time.
For short or medium-term goals, investors can consider debt funds that usually beat inflation by a slight margin and earn better post-tax returns than bank fixed deposits (FD).
In personal finance, the old adage “Don’t put all your eggs in one basket” describes the importance of diversification.
This helps investors avoid concentrating their investments in a particular asset or sector, or theme, also known as concentration risk.
To avoid concentration risk in equity funds, investors can pick funds from different mutual fund companies and avoid investing in multiple schemes from the same category.
You can check the concentration of a mutual fund scheme by comparing the number of stocks or securities held by the fund vis-a-vis its peers. You can also look at the percentage allocation to the fund’s top holdings.
In debt funds, if the portfolio has a significantly high allocation to the papers of the same group companies, it is said to have a high concentration risk.
Investors should refrain from investing in funds with concentrated portfolios as these funds carry higher overall risk.
Diversifying your mutual fund portfolio across different fund houses, sectors, and companies can save you from the risk of losing all your invested money when a common investment threat affects mutual funds.
Risks Associated With Equity Funds
In equity mutual funds, you invest money in stocks of listed companies. The underlying risk here is the volatility of markets which paves the way for fluctuations in stock prices. If the prices of stocks go down, it will negatively impact the mutual fund.
As an investor, you may have to deal with such ups and downs time and again. You can make the best out of these investments only if you are aware of the market risk and stay prepared for it.
Risks Associated With Debt Funds
You’re exposed to this risk while investing in debt funds which invest in fixed-income instruments like debentures and bonds. Companies and governments are the issuers of these instruments, whereas the mutual fund is the lender.
Credit risk or default risk is the inability of the borrower or the issuer of the bonds to pay back the interest and the debt money to the lender/ mutual fund.
As an investor, you can be watchful of the credit quality of the scheme’s portfolio you wish to invest in.
Debt funds that lend to stable companies or buy high-credit quality debt papers have lower credit risk and are considered safer options.
Interest Rate Risk
When the Reserve Bank of India (RBI) changes interest rates, the value of your debt funds will fluctuate. Interest rates and bond prices move in opposite directions.
When the RBI raises interest rates, the old bonds become less attractive as the new ones offer higher interest. This leads to the fall in prices of the old bonds.
So, a rising interest rate scenario deteriorates the value of debt mutual funds. The impact of RBI’s interest rate changes, however, will not be the same on all the debt funds. Price fluctuations would be higher for longer maturity bonds than for those with a shorter maturity.
The probability of occurrence of these risks has a great deal to do with what kind of return your investment in mutual funds will make.
Thus, it is crucial to take into account your risk tolerance and frame your asset allocation accordingly. Taking unnecessary risks can be dangerous to your portfolio as well as your financial health.
(The author is COO, ET Money)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)