Why Are Mutual Funds Subject to Market Risk?

5 mins read
by Angel One

Individuals make financial investments to profit. However, there is no risk-free investment. Although mutual funds provide greater diversification and value for money to investors, a few hazards are connected with investing in mutual funds, which are discussed below. Let’s take a look at some of the dangers that could arise.

Why is investing in mutual funds a risky proposition?

The risk associated with mutual funds emerges because mutual funds invest in various financial instruments like equities, debt, corporate bonds, government securities, & many other types of assets and investments. Many factors influence the price of these instruments, which can cause them to fluctuate and cause them to lose value. As a result, it is critical to determine the risk profile and then invest in the most appropriate fund available.

A person’s Net Asset Value decreases due to price fluctuation or volatility, resulting in a financial loss. In layman’s terms, NAV is the market worth of all schemes in which a person has invested per unit after deducting the liabilities from the total amount invested. Thus, it becomes necessary to determine the risk profile and invest in the most appropriate fund.

Hazards associated with Mutual Funds

There are several different types of hazards involved with mutual funds.

Market Uncertainty

That one-liner in all commercials stating that mutual funds are susceptible to market risk would have been familiar to us all.

Market risk can result in losses for any investor due to the market’s lousy performance over some time. Numerous variables influence the market. Natural disasters, inflation, recession, political instability, interest rate fluctuations, and other similar events are examples of such events. Market risk is called systematic risk in some circles. Diversifying a person’s investment portfolio will not help them in these situations. An investor can only sit back and wait for the right circumstances to present themselves.

Concentration-Related Risk

Concentration is often defined as the act of concentrating on a single task. Concentrating a significant portion of a person’s investment on a single plan is never a wise decision to make. Your profits will be enormous if you’re lucky, but your losses will be significant at times. The most effective method to reduce this risk is to diversify your investment portfolio. Concentrating and extensively investing in a single industry is also a risky strategy—the greater the diversification of the portfolio, the lower the risks.

Risk Associated with Interest Rates

Interest rates fluctuate in response to variations in the amount of credit available from lenders and the demand from borrowers. They have an inverse relationship. An increase in interest rates throughout the investment term may decrease the value of the assets purchased during the period.

If a person decides to invest Rs.100 at a rate of 5% over several years, the result is a profit of Rs.100. Because the interest rate is fixed, if the rate changes for any reason and becomes 6 per cent, the individual will no longer be able to recover the Rs.100 he invested because the rate is no longer fixed. The only alternative available in this situation is to lower the bond’s market value. On the other hand, if the interest rate is reduced to 4 per cent, the investor will be able to sell the investment at a higher price than the amount initially invested.

Risk of Liquidity

In the financial world, liquidity risk refers to the difficulty of redeeming an investment without incurring a loss in the value of the investment. It might also happen when a seller cannot locate a buyer for security. The lock-in period in MFs such as ELSS may endanger liquidity in the fund. During the lock-in time, there is nothing that can be done. Furthermore, exchange-traded funds (ETFs) may be exposed to liquidity risk in a third situation.

 

As you may be aware, exchange-traded funds (ETFs) are similar to stocks in that they may be bought and sold on stock exchanges. You may be unable to redeem your investments at a time when you require them the most. This is due to a lack of purchasers in the market. The most effective strategy to avoid this is to have a broad portfolio and choose the funds with care and precision.

Credit hazard

Credit risk is the possibility that the issuer of the scheme would be unable to pay the promised interest. Typically, rating organisations assess the performance of investment management firms based on these characteristics. As a result, a person will constantly notice that a company with a good rating will pay less than a company with a low rating. Credit risk is also a concern for mutual funds, particularly debt-oriented funds.

Examine the credit ratings of the portfolio composition of a debt fund before investing. In debt funds, the fund manager must include only investment-grade assets in the portfolio. However, the fund manager may include lesser credit-rated assets to get higher returns on the investment. The credit risk of the portfolio would rise as a result of this.

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