Are you a mutual fund investor? Be aware! There are 5 risk involved with your investment
The urge to make more money is universal. The best method for retail investors, of course, is a mutual fund.
Every investment comes with its on risk involved. There is saying, 'with higher risk comes higher returns'. Risk is an inevitable part of any form of investment. Market is a broader concept, and it has its own method of risk associated with investment. The magnitude of this risk can be relative in nature but investments, in general, have risks associated with them. There is no investment which is entirely risk-free. Mutual funds are no different. The urge to make more money is universal. The best method for retail investors, of course, is a mutual fund.
Archit Gupta, Founder & CEO ClearTax says, "Though these funds are primarily known for generating substantial returns for investment, there are risks associated with such investments that an investor must be aware of. It is imperative to identify your risk profile prior to committing to any mutual fund scheme."
According to Gupta, given the nature of mutual funds, the investments are spread across a diverse range of financial instruments making risk an imminent part of it. Financial instruments like equities, debt, corporate bonds, government securities are subjected to market fluctuations.
Changes in the supply and demand equation of these instruments, rise and fall in interest rates, and the shift in inflation, etc. are some of the factors that add to the market fluctuations which in turn leave these instruments exposed to risk.
These fluctuations impact the financial instruments, particularly the Net Asset Value of the investment. NAV is the market value of all the schemes an investor has invested, per unit, after negating any liabilities. In simple words, it is the fund’s market value per share. This is also the price at which investors buy fund shares and sell them to a fund company. Market movements and fluctuations result in the NAV either gaining or declining in value.
There are some additional risks associated with mutual funds as well that an investor must get acquainted with. Some of the risks are as follows, as per ClearTax.
All of us, whether we are ardent investors or not have unmistakably heard the disclaimer - mutual funds are subject to market risk. But only a few are truly aware of what encompasses a market risk. Market risk which is also known as systemic risk is what causes an investor to lose money owing to the dismal performance of the markets. Factors that influence the market adversely are referred to as market risk. This can include anything from a natural disaster to inflation, recession, political unrest, volatility in interest rates, etc. While there is no escaping the market risk, one can lessen the impact of the same by diversifying their investment portfolio but there is nothing more one can do in this regard.
Concentration generally implies converging the focus on one thing. In the realm of finance, concentration risk refers to putting a huge corpus of their investment in just one or a few particular schemes. In the ideal scenario, where conditions are favourable such investments will no doubt achieve an enormous jump in value. But since the scenarios are seldom ideal, it subjects the investment to irreparable damage as well. The best way to ensure that you do not subject your funds to concentration risk is by diversifying your portfolio. With increased diversification, the risk is reduced.
Interest Rate Risk
The changes in the interest rates are directly related to the policy rates decided by RBI. There is an inverse relationship between interest rates and the price of bond securities. An increase in the interest rate results in the decline of the price of securities. For instance, consider an individual investing INR 100 at a rate of 5% for a period of x years. If there is a change in the interest rates owing to changes in the economy, climbing to 6%, the said individual will no longer be able to get back the 100 INR invested. This is due to that fact that the rate is fixed. The only option for the investor would be to reduce the market value of the bond. If the interest rate declines to 4% on the other hand, the investor has the option to sell it at a price above the invested amount.
Liquidity in its simplest forms means cash or an asset which can be easily converted to cash and facilitate in the payment of any service. In mutual funds, this risk takes form in the lock-in period of any investment. One cannot access the investment during its lock-in period. This risk is highest in the case of bonds issued by private players where an investor looking to liquidate his returns can’t do so during the said period. Liquidity risk is low in government issued instruments as there are next to no default in payments by the Government. One way to ensure you don’t get caught in liquidity risk is have a diversified portfolio with ample funds that allow easy access.
Credit risk ensues when the issuer of the scheme fails to make payments promised as interest. To address this issue, agencies that deal in investments are awarded ratings by rating agencies to gauge them. Firms with a higher rating pay less, while those with lower ratings have to compensate the investors for the risk they are taking by investing with them. This means there is more risk involved with a lesser known-low-rated firm than with a firm with credibility. Due to this risk, returns expected from the scheme might even turn out to result in a loss for an individual.
Conclusion : Regardless of what type of investment you venture into, you must always be aware of the risks involved in the same. Risk analysis is an essential aspect of planning that helps in curtailing the possible damage. In the case of mutual funds, understanding the risks facilitates in making better decisions, eliminating the prospects of losses which in turn help in better reinvestment decisions.