Why Are Mutual Funds Subject to Market Risk?

All the mutual fund investment schemes come with a disclaimer. It says that mutual fund investment are subject to market risk. Read all scheme-related documents carefully. 

Mutual fund investments are exposed to various market risks similar to other financial tools. This is mainly because you cannot foresee the future and determine how a particular scheme will perform. Moreover, you cannot anticipate market performance and control it. The market is influenced by various factors and no investments are free from risks here. 

Read on to learn about the factors and reasons that could make mutual fund investments risky. 

What is market risk in mutual funds?

You must already know that all kinds of mutual fund investment are subject to market risk. Reviewing the basics of these investments before comprehending market risks is essential. 

The mutual fund schemes pool funds from multiple investors to create funds in various securities. The value of these securities may fluctuate based on the market conditions and variables. It impacts the specific businesses and sectors that they represent.  

The market risks basically indicate the potential decline in the financial markets. It may affect the investment value in the mutual funds. This risk may arise from several variables like economic and political events. These mutual funds risk factors may include inflation, interest rates and global trends too. Therefore, mutual fund schemes investing in different securities make them prone to market risks.

Types of Market Risks

You must be wondering why mutual fund investment are subject to market risk. There are several components that are deemed as market risk factors for mutual funds. It may affect different types of investments. The most common types of risk in mutual funds are discussed below. The kind of market risk faced by mutual funds is based on the allocated assets in their portfolio. 

1. Equity Risk

The Equity risk relates to the portfolios of mutual funds that invest in company stocks and equities. Stocks are typically volatile which fluctuate due to a variety of market activity. 

2. Concentration Risk

You can concentrate a large part of your money on a single stock, asset and sector. It is rarely a good strategy. You can earn a decent profit if you’re lucky but the losses may be considerable at times. You can diversify your portfolio which is an effective way to reduce this risk. Thus, concentrating and heavily investing in a single industry is not advisable. The risk decreases when the portfolio diversifies.

3. Interest Rate Risk

Debt investments such as corporate bonds and government are vulnerable to risks associated with interest rate. The Reserve Bank of India sets interest rates. When the Reserve Bank of India raises the interest rates, the existing bond’s value may fall or decline. Money market funds, bond funds and balanced funds are all susceptible to this type of risk.

4. Liquidity Risk

Liquidity risk refers to the difficulty of redeeming assets without losing value. This occurs when there are no buyers in the market when a seller attempts to sell their investments. The lock in period in mutual funds can increase liquidity risk because these products cannot be sold.

5. Credit Risk

Credit risk indicates that the scheme’s issuer will be unable to repay the promised interest. Rating organisations frequently use these criteria to evaluate investment firms. So, you will find that a corporation with a good rating will pay a lower interest rate on your deposit. The one with a lower rating pays a good interest and vice versa. Credit risk also impacts mutual funds like debt funds.

Debt funds must only contain investment-grade assets, according to the fund management. However, the fund management may include lower credit-rated assets to obtain higher returns. This would increase the portfolio’s credit risk. Before investing in a debt fund, you should check the credit ratings of the portfolio composition.

6. Inflation Risk

In the event of growing inflation, the value of currency steadily decreases over time. Money market funds are particularly vulnerable to inflation since their returns are lower. During instances of strong inflation, equities outperform money markets.

7. Socio-Political Risk/Country Risk

Events such as war, terrorism, or political elections may have a detrimental impact on the market. These dangers are referred to as sociopolitical risks. On the other hand, country risk refers to the same phenomena but solely for events that affect investments in other countries.

Mutual fund investments diversify risk but are considered risky

Mutual fund is subject to market risk. They invest in securities like debt and stock whose values change in response to market movements. It makes them dangerous because the fund’s NAV is based on the individual securities values in its portfolio. Mutual funds, on the other hand, spread market risk by investing in assets from several industries. 

Because a fund invests in a variety of assets, the danger that they may all lose value on the same day is decreased. Thus, mutual funds distribute risk but do not remove it. Diversification implemented by a fund manager minimises the fund’s market risk to the extent of diversification. A fund’s risk level decreases as its diversification increases. 

Concentrated funds, such as thematic or sector funds, are riskier than multi-cap funds because they will affect all of the companies in the affected sector in some way, whereas in a multi-cap fund, diversification across sectors and capitalisation acts as an airbag during a car accident, reducing the impact of the unfavourable condition on the fund’s net asset value.

When investing in mutual funds, consider the level of diversification in the fund’s sector allocation. Select a fund with the appropriate diversification for you depending on your risk tolerance.

How to deal with market risk?

Now that you understand that mutual fund investments are exposed to market risk, let us look at some actions we may take to reduce it. While market risk cannot be eradicated entirely, there are techniques for dealing with it and reducing its influence on your assets.

• Diversification: Diversifying your mutual fund portfolio might be an excellent approach to minimise risk. Investing in funds covering many asset classes, such as stocks, bonds, and commodities, diversifies your risk across sectors and instruments. Diversification helps to offset the effects of a single underperforming asset or industry.
• Systematic investment plan (SIP): A SIP allows you to invest a certain amount in a mutual fund at predetermined intervals, independent of market conditions. By spending a certain amount at regular periods, you can purchase more units while prices are low and less units when prices are high. This method, known as rupee-cost averaging, helps to mitigate the effects of market volatility on your assets over time.

Conclusion

With this, you should be aware of the hazards connected with mutual funds. Despite these dangers, mutual funds are an excellent long-term investment vehicle. However, mutual funds are only suitable if you are ready to accept risks. If not, there are several additional low-risk investing opportunities accessible. 

However, conducting research and selecting the appropriate funds for your risk tolerance is critical. A compound annual growth rate calculator may help you estimate the returns you can expect from a mutual fund. Lastly, remember to consult a professional and embark on a safe mutual fund investment journey.  

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