Risk in Mutual Funds: Types of Risks Involved in Mutual Funds

22 May 2023|

3 min read |

by ICICI Securities Team

Mutual funds are popular investment vehicles that pool money from several investors to invest in different asset classes. They are preferred due to their convenience and the potential for high returns. However, like any investment, mutual funds also have their own set of risks. In this article, we will explore some mutual fund risks and how investors can mitigate these mutual fund risks.

What makes Mutual Fund Investment Risky?

There are several factors due to which mutual fund investment can be considered risky. These factors are:

1. Mutual funds invest in a variety of financial securities, including equities, bonds, and other instruments. The prices of these assets fluctuate constantly as per the market conditions and this market volatility impacts the NAV of the mutual fund portfolio

2. Rsk of poor investment decisions made by the fund managers or when they fail to predict changes in the market, leading to losses for investors

Along with these, there are several other types of risk in mutual funds that investors need to understand and conducting thorough research can help them mitigate these mutual fund risks.

Types of Risk in Mutual Funds

Mutual funds have some inherent risks even though they are diverse investing solutions. Some very common types of risks in mutual funds are mentioned below.

Market Risk

Market risk is the risk of the market’s bad performance that may pose a threat of loss for any investor. The market is influenced by several factors. A natural disaster, inflation, a recession, political instability, a change in interest rates, and other similar events can have a significant impact on the market.

Concentration Risk

Usually, to concentrate is to give your full attention to one object. If you're lucky, the profits will be enormous, but the losses will occasionally be stark. Diversifying your portfolio is a good strategy to reduce this risk. Investing significantly and concentrating on one industry is risky as well. The risk decreases as the portfolio becomes more diverse.

Interest Rate Risk

Interest rate risk is typically faced by debt mutual funds. The availability of credit from lenders and the demand from borrowers both affect interest rates. The price of securities could be impacted due to the changes in the interest rates throughout the investing period.

Liquidity Risk

Liquidity risk is when investors find it difficult to redeem their investment without suffering a loss. This risk is faced by mutual funds that have a lock-in period such as Equity Linked Saving Schemes. It becomes difficult to sell the investments when there are not enough buyers in the market.

Credit Risk

Credit risk refers to the possibility that the scheme’s issuer cannot fulfil its interest-payment obligations. Rating agencies typically grade companies that handle investments based on these factors. One will, therefore, constantly notice that a company with a good rating will pay less and vice versa. Credit risk affects mutual funds, especially debt funds.

The fund manager must only include investment-grade securities in debt funds. Yet, it is possible that the fund management will occasionally add lesser credit-rated securities to generate larger returns. The portfolio’s credit risk would rise as a result. Hence, it becomes essential to look at the portfolio composition’s credit ratings before investing in a debt fund.

How to Combat Risks Associated with Mutual Funds

Mutual funds can be a terrific method to diversify your portfolio and invest in the stock market. However, there are complexities associated, just as with any other investment. Here are a few tips that will assist you in combating risks associated with mutual funds:

Examine the past performance, costs, and investment strategy of a mutual fund before investing.
Diversify your portfolio by investing in various companies and industries. By spreading out the assets in your mutual funds, you can reduce your overall risk
Keep a watch on your investments to maintain your portfolio aligned with your investing goals, keep a close check on your investments periodically and make the necessary modifications
With a systematic investment plan, you can invest in mutual funds over time in little amounts as opposed to all at once.
Long-term mutual fund investing can help to lower the risks associated with mutual funds as it navigates short-term market turbulences

FAQs on Risks Associated with Mutual Funds

Is it risky to invest in mutual funds now?

Mutual funds involve inherent risk, as their value depends on the market. There's no guarantee of profit, but diversification can spread risk. Consider your goals and risk tolerance before investing.

Are mutual funds riskier than stocks?

Generally, mutual funds are considered less risky than individual stocks. Diversification across holdings helps spread risk. However, some mutual funds, like those focused on a single sector, can be just as risky as stocks.

Can mutual funds go to zero?

It's very unlikely. Mutual funds hold many investments, so a complete meltdown is rare. While the value can swing with the market, it's highly improbable to drop to zero.

Is mutual fund risky in the long term?

Although all investments carry risks, mutual funds are relatively less risky in the long run. This is because diversification across holdings can help ride out market dips. The longer one stays invested, the more time one has to ride out the short-term fluctuations.

Who should not invest in mutual funds?

Mutual funds may not be the best option if you need your money in under 5 years. After all, mutual funds can get quite volatile. If you are the type of person who loves to choose a stock for themselves and is an aggressive investor, then you might consider going for individual stocks.

What is the safest type of mutual fund?

Government bond funds are the safest form of mutual fund. They accept lower returns compared to stock-based funds but have less chance of swings in value.

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