Types of Risks in Mutual Funds & How to Manage Them

Mutual funds offer an excellent way to grow wealth but they involve risks. Every investor has heard the familiar disclaimer—”Mutual fund investments are subject to market risks. Read all scheme-related documents carefully.” But what does this really mean? Mutual funds invest in financial instruments like equities, bonds, and corporate debt, all of which fluctuate due to market forces, economic conditions, and global events. 

Continue reading this article to learn about risks in mutual funds and how to overcome them with smart strategies. 

Why are Mutual Funds Risky?

Mutual funds are risky financial instruments as they invest in financial products such as equities, bonds, and corporate debt whose values change according to market forces. The NAV of a fund is based on these instruments and is prone to sudden drops. Moreover, the market volatility, the state of the economy, geopolitical factors, and policy changes all contribute to such risks.

No fund manager can offer guarantees on returns since market volatility. While there are less-risky funds available compared to others, every investment in a mutual fund carries risks associated with markets. Investors need to understand that interest rate fluctuation, inflation, and external events can affect the risk in mutual fund investment.

Different Types of Risks in Mutual Funds

Mutual funds involve several risks other than market volatility. Knowledge of these risks enables investors to make the right choices. Here are the different types of mutual fund investment risks:

1. Market Risk: Market performance is influenced by external factors such as economic decline, geopolitical events, policy shifts, and natural calamities. Unpredictable factors like these lower returns.
2. Concentration Risk: Placing too large a portion of one’s investment in one sector, asset class, or firm can prove hazardous. If that sector performs poorly, the whole portfolio declines. Diversification saves the investor from this risk.
3. Interest Rate Risk: Debt mutual funds are most sensitive to interest rate movements. As interest rates increase, bond prices decrease, which translates into decreased returns for the funds.
4. Inflation Risk: Inflation reduces purchasing power and impacts real returns. With high inflation, even what might appear to be good returns might not keep pace with increasing expenses.
5. Liquidity Risk: Certain funds invest in illiquid assets that cannot be sold quickly, resulting in losses when investors attempt to redeem their investments.
6. Credit Risk: Debt funds have the risk of default by the issuers of bonds, affecting fund performance.
7. Expense Ratio: Commissions and high management fees consume returns in the long run.
8. Manager Risk: The fund’s performance is contingent on the manager’s decision-making. Incorrect decisions may result in underperformance, influencing investor returns.

Strategies for Managing Risks in Mutual Funds

Risk in mutual fund investment involves inherent risks, but careful planning can minimise them. Following are some effective methods to minimise risk and maximise potential returns:

• Diversify Your Portfolio: Investing in different sectors and asset classes minimises exposure to the decline of a single sector. A diversified portfolio consists of equity, debt, and hybrid funds. In addition, combining large, mid and small-cap funds optimises risk and reward.
• Invest via SIPs: A Systematic Investment Plan (SIP) enables investors to invest a fixed amount at periodic intervals, which lessens the effect of market fluctuations. Rupee cost averaging helps to purchase more units when prices are low and fewer units when prices are high, thereby decreasing overall investment risk.
• Measure Your Risk Profile: It is important to understand your risk tolerance. Investors should match their portfolio with their comfort level and select a combination of equity and debt funds accordingly. 
• Invest With a Goal: Choosing the right mutual funds depends on your financial goals. Retirement, a long-term goal, can be achieved with equity funds. 
• Stay Invested for the Long Term: Investing for the long term helps to reduce market volatility in the short term. The compounding power also helps in delivering higher returns over the years, making patience the most important ingredient in mutual fund success.

Final Thoughts

Mutual funds have inbuilt risks, but knowing them gives investors the power to make active choices. Although market fluctuations, economic changes, and uncontrollable factors may affect returns, careful planning like diversification, SIP investment, and goal-based investing can minimise risk in mutual funds. No investment is completely free from risk, but with long-term and patience-oriented decisions, mutual funds can prove to be a lucrative financial instrument. 

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