Mutual fund investments are subject to market risks, read all scheme related documents carefully.” We have come across this statement in various commercials, ads, documents, etc. In commercials, they say it very quickly so we can hardly comprehend what they are saying. And in documents, it would be written in such small fonts, that we can hardly notice it.

There is hardly/no investment without a risk attached to it. Just like any other investment, mutual fund investments also have their inherent risks, only the degree and nature of the risks vary. A point to note here is that investing in debt or equity market through mutual funds diversifies your portfolio and hence, reduces your risk to a very large extent when compared to direct exposure to those scrips. The operative here is “reduction in risk” and not complete elimination. Since these funds are directly connected to the market, these risks will still remain and not completely vanish away.

Let us look at the most common risks prevailing today based on the type of mutual fund scheme –

  1. Credit risk – if you invest in a particular scheme and the issuer defaults in repaying you either the interest, the principal or both, then you are at a credit risk. This risk is widely present in debt mutual fund schemes. Hence, before investing in a debt fund, you must ascertain its credit rating/grade.
  2. Interest rate risk – you might not even have considered this as a factor in choosing a mutual fund scheme. Remember, interest rate and the bond price is inversely related. If the interest rate increases, the bond value or NAV reduces and vice versa. We cannot predict when this change might occur because it really depends on political and economic factors. Again, debt mutual funds are attached to this risk.
  3. Liquidity risk – this risk occurs when you are unable to encash or liquidate your mutual fund holdings at a given point of time at a reasonable price. In case you have an urgent requirement of cash, then you might have to ask your fund manager to sell at a lower price and thus, incur a loss. Small-cap mutual fund schemes face this risk because there won’t be many buyers in this category.
  4. Price risk – this simply refers to the extremity in prices of the scrips. I guess you might have guessed it by now when I mention about the extreme movement of prices, yes equity mutual funds bear the price risk. Although, a very important and practical point to keep in mind is that, you face the price risk in equity investing only if it is done for a short term. Long-term equity investing actually escapes not only this risk but also the inflation risk. This is the only asset class which can beat inflation risk and gives you handsome returns over a long period of time. So in a sense, the price risk-taking is definitely worth it over a long period of time. Past performance of a fund should not be the only deciding factor before deciding on it, because the trend may keep changing. A more holistic assessment should be done before delving into it.
  5. Concentration risk – as the name suggests, if all your money is pooled into one sector/company, there is a higher chance of opportunity loss because if that particular sector doesn’t perform up to your expectations, there is no other avenue for you to compensate your loss. This is called poor diversification. Sectoral mutual funds are an example for this category.
  6. Systematic risk – these are risks that you cannot do anything about. Like foreign exchange fluctuation, oil price hike, bad weather conditions causing low productivity, political factors, etc. The only thing you can do is wise in deciding on scrips which depend too much on these factors and limit your exposure to them.
  7. Business risk – this risk relates to and is directly connected with the operations of a company or a sector. Sudden labor strikes, poor financial performance, etc. are reasons that can cause the scrip to not do well. Usually, fund managers are expert enough to mitigate this risk for you by diversifying well enough into other companies. But if you opt for a Sectoral mutual fund, then you may not be able to escape this risk.

Now that we have discussed most types of risks involved in mutual fund investing, let me tell you the biggest risk that you might be facing. The biggest risk is not investing in a mutual fund at all. Inflation diminishes the value of money and the future is uncertain. Hence it is utmost important that you plan and take risk appropriately, consult a mutual fund expert and get investing!