Risks can be mitigated, but they cannot be eliminated. Two primary risks are associated with every investment: systematic and unsystematic.
Risks associated with mutual fund investments are broadly classified as follows:
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The systematic risk or market risk translates to the stock market conditions. We all have heard ‘mutual fund investments are subject to market risks. The returns from the scheme are not guaranteed, and there is no assurance that your investment will increase in value. The market constantly fluctuates, so your assets may not rise as quickly as you anticipated. Furthermore, there is a good probability that the investment value may even decline.
This is because numerous variables influence market risk. Future events cannot be predicted, and the market is no different.
Market risk consists of numerous factors. Investments are vulnerable to market risk based primarily on the following risk factors:
Equity risk relates to stock market investments. When an investor decides to sell a certain investment, the fluctuating prices on the stock market could lower its value. The value of mutual funds may fluctuate, causing unitholder’s investments to depreciate. The market also affects the value of the mutual fund’s holdings. Consequently, equities mutual funds are very susceptible to market changes. Equally exposed to equity risk are balanced mutual funds that invest in stocks.
Never invest a major amount of your financial resources in a single scheme. The earnings will be tremendous if fortunate, but so will the losses. Diversifying your investments is the most effective means of mitigating this risk. Investing and focusing heavily on a single industry or sector is similarly risky. The more diversified a portfolio is, the lower its risk. Thus, you should aim to diversify your exposure across asset classes and industries.
Investments in debt instruments, such as corporate and government bonds, are susceptible to interest rate risk. This risk applies when RBI increases interest rates. Existing bonds will be worth less if interest rates increase. This risk impacts bonds, money market mutual funds, and balanced mutual funds.
Credit risk is the possibility that the scheme’s issuer defaults on interest payments. On the basis of these factors, rating agencies evaluate investments. A corporation with a high rating will always pay less interest, and vice versa. This is due to the low likelihood of default associated with highly rated securities. Credit risk has an impact on mutual funds, particularly debt mutual funds.
Before investing in a debt fund, check the portfolio’s credit ratings. Fund managers may include lower-rated securities to increase mutual fund returns. This increases the credit risk of a portfolio.
The inability to exit an investment without incurring a loss is a liquidity risk. It occurs when the investor is unable to sell their units. Lock-in periods in mutual funds, such as ELSS might provide a liquidity risk. Lock-in in an investment means you cannot sell it during the lock-in period.
Like stocks, ETFs can be bought and sold. ETFs may be subject to liquidity issues. Sometimes, you cannot sell your mutual fund units when you need them due to a lack of purchasers. To avoid this, diversify your portfolio and choose your mutual funds carefully.
Inflation risk is the likelihood that your money’s purchasing power and long-term investments’ value will diminish over time. Due to the poor returns of money market mutual funds, they could be easily surpassed by inflation over time. These funds are particularly exposed to inflation risk.
Socio-political risk is the probability that war, terrorist acts, or political elections will have a negative impact on the market as a whole.
Foreign policy and economic shifts pose a threat to the mutual fund’s investments. Certain legislative changes or economic volatility in the foreign country could have an effect on the returns of the mutual fund.
The unsystematic risk or specific risk is the risk that is not specific to the overall stock market. Instead, it is specific, only a certain industry or business. For instance, a scarcity of oil could have an impact on the oil sector. A pharmaceutical company’s value could decline if a medicine is recalled. Even the weather can be a variable. Following are the types of unsystematic risks:
- Business risk: This could refer to a problem with a certain product or service and internal or external problems that a company may face.
- Financial risk: Poor quarterly earnings or a lack of cash flow are financial reasons that can lead to a decline in a company’s stock price.