Risks of investing in Mutual Fund Schemes
Many people think, that mutual funds are one of the safest investments. They are unaware of the fact that mutual funds also carry a number of risks. SEBI instructed mutual fund AMCs to put a specific risk disclaimer when advertising mutual fund schemes. However, many investors would not read them. Some investors are commenting on our blog saying they want to invest in mutual funds which are zero risk. There is nothing like zero risk mutual funds in India. What are SEBI guidelines to MF schemes about risks? Why should you understand about the risks in mutual funds? Which are various Risks of investing in Mutual Fund Schemes?
What are mutual funds?
Mutual funds are investment schemes in which a pool of money is collected from various investors for the purpose of investing in securities like stocks, bonds, market securities or a combination of these. These funds are managed professionally and a minimum fee is charged for it. There is a variety of categories in which mutual funds can be categorized like debt funds, equity funds or hybrid funds.
Like most investments, mutual funds do carry risks, i.e. you could lose money on your investments. However, the level of risk in a mutual fund depends upon what he/she invests in. Generally, the higher are the potential returns, the higher the risk would be. Like, equity funds are riskier than fixed income bonds.
What are SEBI guidelines to MF schemes about risks?
“Mutual fund investments are subject to market risk, please read the offer document carefully before investing.”
We all might have heard this statutory warning issued by SEBI every now and then. But most of us ignore it like any other warning. Have you ever thought about over about the risks associated with the mutual fund. Over the years, SEBI has strengthened the mutual fund regulations in order to minimize the risk, but it is rather impossible to avoid the risks of all kinds.
Why should you understand about the risks in mutual funds?
A risk is inherent to investing. There is hardly any investment that is risk-free. Mutual funds are also risky. It invests in a variety of financial instruments like equities, debt, government securities, corporate bonds, etc. So in a way, through mutual funds, you are investing in financial markets only which is exposed to risks of various degree. Both equity and debt funds carry risk. But, debt funds are not as risky as equity funds. The tendency of being volatile, equity is risky, especially in a short and medium term.
8 Risks of investing in Mutual Fund Schemes
1) Market Risks in Mutual Fund Schemes
It is always mentioned that mutual fund investments are subject to market risk. Market risk is associated with the poor performance of the stock market. The overall performance of the market might not be good due to natural calamity, political unrest, recession, etc. The diversification of the mutual funds portfolio is also not the solution is under this situation. As an investor, one cannot do anything else than to wait for a suitable time only.
2) Liquidity Risk in Mutual Fund Schemes
Liquidity risk means the difficulty in redeeming the investment at the cost which is at par with the cost price. In the case of mutual funds, the lock-in period freezes your liquidity. Nothing can be done during this period, even if you need your funds the most. Hence, you should invest in equity mutual funds atleast 8-10 years while some of the funds like balanced funds can be invested for 5 year period.
3) Interest Rate Risk in Mutual Fund Schemes
Interest rates keep on changing depending upon the credit availability with lenders and the demand from borrowers. These are related inversely to each other. A hike in the interest rate during the investment period may result in the reduction of price in the securities. These would largely effect debt funds and to some extend in equity funds (which invests some portion in fixed income securities).
4) Currency Risk in Mutual Fund Schemes
The investments that are made in denominations other than the local currency are exposed to currency risks. If the investment is made in a foreign country and the value of relevant currency declines, then ultimately it leads to the decline in the value of the investment. Currency risk is largely exposed in international mutual funds.
5) Credit Risk in Mutual Fund Schemes
If you invest in a debt mutual fund and the bond issuer comes in default, it is a credit risk. For instance, you lend Rs 50,000 to your friend for a year. After the period, your friend fails to pay you the money back. This is called credit risk. One needs to make a thorough study about the portfolio characteristics held by the debt mutual fund scheme. You must ensure that the fund manager invests in high-grade securities. Hence one should invest in 2-3 debt funds instead of 1 fund.
6) Country Risk in Mutual Fund Schemes
When an investor invests in mutual funds in other countries, they are exposed to the political or economic instability, natural calamity etc. in that country. E.g. there are international mtual funds which invest in specific country like China or Brazil. Hence you should check how such country risk would effect you before investing in such funds.
7) Concentration Risk in Mutual Fund Schemes
It is an old saying that do not put all your eggs in a single basket. The same concept applies here. One should not invest all his money in a single scheme. If you are lucky, then you may fetch good sums of money, but the possibilities of losses are more. If that particular sector under performs, there will be huge losses. The best way to avoid this risk is to diversify the portfolio. Highly diversified portfolios are less risky.
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8) Business Risk in Mutual Fund Schemes
Business risk in mutual fund schemes refers to the possibility that an issuer of the bond or stock experiences a loss and in case of bonds unable to pay the interest of principal repayment. For this reason, it is said that the mutual fund scheme should have a diversified portfolio.
Conclusion: Mutual funds are risky investment instruments that do not offer guaranteed returns. But the risk can be controlled to some extent through a wise and proper selection of mutual funds. One must read the Scheme Information Document (SID) very carefully which would help you to understand which risks apply to your selected scheme.
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Risks of investing in Mutual Fund Schemes
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