The importance of understanding risks in mutual funds

Like all other investment possibilities, risk is an unavoidable part of investing. Different investments have different points of the risk spectrum. Just like that, mutual funds also carry risks. Mutual funds are known to be one of the most preferred investment instruments. They are both great investment options and come with a certain amount of risk. Both risk and return are two sides of the same coin. High return involves high risk and vice versa, therefore it is critical to take the required risk in order to earn the potential return. Learning your own risk profile in mutual funds is crucial before you start investing.

Understanding your risk appetite to choose investments
First, let’s understand exactly what ‘risk’ is. In investing, the risk is the other term for fluctuation in price. An investment that is susceptible to uncontrolled actions in either direction is considered to be favorably risky. While investing, to be able to select the right funds you need to be aware of your risk appetite. Risk appetite directs you to the ability and willingness to tolerate the loss of your investment. Risk tolerance is a very subjective matter that relies on your financial situation as well as psychological characteristics.

If you are an aggressive investor, you are mostly ready to take a higher risk in anticipation of higher returns. On the other hand, a conservative investor would be satisfied with low returns in return for lower risk. Thus, the outcomes a person aged 60 years uses for building a retirement corpus may be significantly distinct from what a person aged 40 or 30 years may decide for the same goal. So, positioning investments with your risk appetite is essential for gaining returns.

Mutual funds risks and its types

Risks associated with equity mutual funds

• Risk of losing funds
  You should not invest in equity schemes unless you can afford to take the risk of possible loss of principal.
• Market Risk
  Equity shares are inclined to price fluctuations on a daily basis. Poor market performance can result in losses. There are multiple factors that have an impact on market performance.
• Liquidity Risk
  This is the risk of not being able to liquidate your investment at a moment of need. With mutual funds like ELSS, the lock-in period may result in liquidity risk. You can do nothing during this lock-in period. Nonetheless, exchange-traded funds (ETFs) might also suffer from liquidity risk. Sometimes due to a shortage of buyers in the market, you might be unable to redeem your investments. The most suitable way to avoid this is to have a remarkably diverse portfolio and to select the fund diligently.

Risks associated with debt mutual funds

• Interest Rate Risk
  The risk is that rising interest rates will drive your mutual funds to decline in value. When interest rates increase, bond prices drop and bond mutual funds may also decline as a result. Therefore, the value of a scheme portfolio may decline if the market interest rate increases. The extent of the decline or rise in the prices relies upon the coupon and maturity of the security.
• Credit Risk
  This type of risk implies your inability to pay the promised interest. Here, the credit rating agencies rate the asset depending on certain criteria. High-rated bonds have low credit risk. And, low-rate bonds have high credit risk. Basically, a credit rating indicates your ability to pay interest and principal. A high rating points to low chances of default and vice versa.
• Spread Risk
  Depending on the market conditions, credit spreads on corporate bonds may vary. The market value of debt securities may decline if the credit spreads broaden and vice versa. Likewise, with floating rate securities, if the spreads over the standard security/index broaden, then the value of such securities may decline.
• Concentration Risk
  This kind of risk refers to having high exposure to one particular asset. Investing completely in just one company’s stocks often abides a considerable risk of losing capital if caught during bad market situations.
• Prepayment Risk
  This risk means paying off the loan sooner than the due date, resulting in a change in the yield and tenor for the mutual fund scheme. When interest rates drop, you tend to pay off high-interest loans with money borrowed at a lower interest rate. This will shorten the average maturity of asset-backed securities (ABS).
• Rebalancing Risk
  In this, the fund managers rebalance and review mutual fund investments on a frequent basis. However, regular reinvestments come with the risk of missing out on investment growth chances. Also, frequent rebalancing will raise the costs associated with the fund’s management.
• Risk is unavoidable. Nevertheless, how you fight the risk is all that matters. Mutual fund investments could be risky but they have the potential to generate notable growth. An investment plan executed with care might help you achieve your dreams.

Disclaimer
An investor education initiative by ICICI Prudential Mutual FundVisit www.icicipruamc.com/note to know more about the process to complete a one-time Know Your Customer (KYC) requirement to invest in Mutual Funds. Investors should only deal with registered Mutual Funds, details of which can be verified on the SEBI website http://www.sebi.gov.in/intermediaries.html For any queries, complaints & grievance redressal, investors may reach out to the AMCs and/or Investor Relations Officers. Additionally, investors may also lodge complaints on https://scores.gov.in if they are unsatisfied with the resolutions given by AMCs. SCORES portal facilitates you to lodge your complaint online with SEBI and subsequently view its status.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.