9 mutual fund risks that you should be well-versed with

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Investing in mutual funds is not risk-free, and returns are dependent on market conditions. Although mutual funds are regarded as a relatively safe investment vehicle, their performance is subject to market fluctuations. Investing in mutual funds, like any other investment, comes with specific risks. Through a fund manager, your mutual fund investment is distributed among several financial products.

The risk involved in mutual funds is influenced by various factors, including the government’s economic policies, current economic conditions in the country, the demand-supply gap, and so on. You must choose your mutual fund carefully to maximise your return on investment. Let’s understand the different kinds of mutual fund risks that you need to know while investing in mutual funds:

1. Interest rate risk

Interest rates in a market reflect the availability of credit, and the status of the economy has an impact on it. Fixed-income mutual funds and investments, such as debt funds are frequently affected. Bonds appear less beneficial than alternative investment possibilities as interest rates rise, and their prices fall, and vice-versa.

While it usually is debt funds that are adversely impacted by interest rate increases, it is also possible that the value of equity-oriented funds would drop in the short term. When investing in mutual funds, keep a long time frame in mind to guarantee that the adverse effects of increased interest rates are balanced out.

2. Market risks

This is the risk you incur when you invest in the stock market. Market risk is classified as systematic because every market has its own cycle and patterns. Due to unfavourable market conditions, your investment may suffer in market risk.

To protect yourself from market risks, create a well-diversified portfolio with a balanced equity and debt investments allocation. Furthermore, you must invest in mutual funds for a more extended period of time to ensure that the market’s ups and downs are averaged out and that you receive the desired returns.

3. Risk of Inflation

Inflation risk refers to the risk of an investor’s buying power being eroded owing to rising commodity prices. As an investor, you’d like to see a higher return on your investment than the current inflation rate. For example, if you invest money in mutual funds and earn a 7% return, but inflation is at 4% during the same time period, your net purchasing power increases by just 3%.

That said, when choosing mutual funds, be sure the funds you choose can outperform inflation. Equity-oriented mutual funds are often thought to have a high-return potential that can outperform inflation. They do, however, come with a particular element of risk.

4. Lower liquidity risk

Liquidity risk refers to the perils of a market with less liquidity. This could happen for various reasons, including an increase in interest rates, a change in the value of the currency, and so on. Liquidity in the financial sector refers to the capacity to swiftly sell an asset to raise funds.

Liquidity risk is present in investment products with long lock-in periods, such as fixed deposits and ELSS-based mutual funds. Similarly, it may be difficult to sell Exchange Traded Funds (ETFs) without incurring losses during a liquidity crisis.

While it directly affects these funds, it has a detrimental influence on all types of mutual funds since the fund manager finds it difficult to sell equities on the stock exchange without incurring losses.

5. Credit risk

Credit risk refers to the risk of a bond defaulting due to non-payment by the lender. As a result, all mutual funds with bond exposure are affected. Bonds are given ratings by credible organisations depending on the risk they pose. PSU bonds, also known as AAA bonds, are the safest and have the lowest credit risk.

Before you invest in a debt fund, look at its credit rating. Additionally, diversify your portfolio to protect your investment.

6. Concentration risk

Concentration risk occurs when you put all of your money into one mutual fund or sector. Your entire investment is  harmed if the industry falls due to government policies or insolvency. To manage risk, all financial experts recommend diversifying your portfolio by investing in several sectoral funds to avoid the concentration risk.

7. Possibility of principal loss

Portfolio managers can’t guarantee the fund’s performance, which means there’s a chance you’ll lose money.

8. Diversification’s diluting effect

Diversification in a mutual fund can sometimes dilute beneficial gains. For example, if one of the fund’s stocks doubles in value, the fund’s overall performance may not necessarily reflect this.

9. Systematic and unsystematic risks

Risks that you can’t prevent since they’re out of your control are known as systematic risks. Systematic risks, for example, include any regulation that affects a large number of assets.

Unsystematic risks, also known as unique risks, affect a single mutual fund class or a group of mutual funds. Any accident or criminal investigation of a company, for example, can lower its stock value.