Types of Risk Involved in Mutual Fund Investments

Definition of Risk

Risk in mutual funds refers to the uncertainty of achieving expected returns due to various factors affecting the fund's performance. While some level of risk is inherent in any investment, understanding the risks involved is crucial for making informed investment decisions.

Importance of Understanding Risks

Investors must assess their risk tolerance and understand the potential risks associated with mutual fund investment to align their investment objectives with their risk preferences. Ignoring or underestimating risks can lead to unexpected losses and undermine long-term investment goals.

So this blog will dig deeper into 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 mutual funds), the risks involved in capital markets get translated to the mutual fund also. Hence, let’s take a look at the risks associated with capital markets:

Systematic Risks:

Systematic Risk is the risk which you cannot avoid.

Example: Government policies change, Exchange rate inflation, Oil price hike

Market Risk: Also known as Beta, market risk affects equity investments, making them susceptible to volatility. Market fluctuations can significantly impact the value of equity investments.

Interest Rate Risk: Debt markets are vulnerable to interest rate fluctuations, influenced by movements in the RBI's repo rate. Changes in bond prices are inversely proportional to interest rate movements.

Inflation Risk: Rising inflation reduces investors' purchasing power, impacting their capacity to invest and potentially affecting investment returns.

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 at any given point in the market, there will be one asset class that will outperform others. But at the same time, during volatility in the 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.

Unsystematic Risk:

Unsystematic risks are specific to individual companies or sectors and include.

One of the best examples of Unsystematic risk is IL&FS default and Jet Airways shutting down its operations.

Financial risk: It 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: It 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 market capitalization which perform differently 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.

The 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 risk appetite. This will help you to make long-term mutual fund investments.

If you want to calculate Mutual fund risks there are various mutual fund calculators available that you can check easily.