Like all other securities, mutual funds are vulnerable to market (also known as systematic risk). Since it is impossible to anticipate how the asset reacts to different market conditions in the future or whether the value of a certain item will increase or decrease. No investment is risk-free since the market cannot be correctly predicted or controlled.
What is Market Risk?
Market risk is inherent in all forms of investments due to the volatile nature of the market and the global economy as a whole. Market risk is the probability that the market or economy will decline, leading individual investments to lose value. This is irrespective of the performance or profitability of the business.
During the 2008 stock market meltdown, for instance, literally, all the stocks in the market lost their value. Despite the fact that the majority of companies hadn’t done anything or altered their operations. No single company could have predicted or prevented the outcome.
Thus it is next to impossible to predict the market sentiments.
Important Risk Factors To Note Before Investing in Mutual Funds
There are numerous market risk components that apply to various sorts of investments. Equity risk, interest rate risk, credit risk, inflation risk, socio-political risk, and country risk are typical categories of market risk. Multiple sorts of market risk can affect certain types of investments. The sort of market risk applicable to mutual funds depends on the portfolio holdings.
Equity risk pertains to investments in the stock market. The fluctuating prices on the stock market could reduce the value of an individual investment when the investor decides to sell. The value of mutual funds might change, resulting in a depreciation of shareholder investments. The value of stocks held in the mutual fund also depends on the market. Thus, equity mutual funds are quite sensitive to market trends. Balanced mutual funds that invest in stocks are likewise susceptible to equity risk.
Concentration refers to focusing on a single thing. Investing a significant portion of one’s capital in a single scheme is never a wise decision. If fortunate, profits will be enormous, but losses will also be significant. The most effective method for mitigating this risk is to diversify your investments. Concentrating and investing extensively in a single industry or sector is likewise dangerous. The greater the portfolio’s diversification, the lower its risk. Thus, ensure your exposure is well diversified across asset classes and sectors.
Interest Rate Risk
Investments in debt instruments, such as government and corporate bonds, are subject to interest rate risk. This risk pertains to the chance of rising interest rates, as mandated by the RBI. Rising interest rates will reduce the value of existing bonds. This risk affects bonds, the money market, and balanced mutual funds. The risk that a bond issue would default applies to bond funds as well.
Credit risk refers to the scheme’s issuer default with respect to interest payments. On these criteria, rating organizations rate an investment. A high-rated company will always pay less, and vice versa. This is because the chances of default are low with a highly rated company. Credit risk affects mutual funds, especially debt mutual funds.
Mutual fund managers may include lower-rated securities to boost returns. This increases portfolio credit risk. Check the portfolio’s credit ratings before investing in a debt fund.
Liquidity risk is the inability to exit an investment without a loss. It is when a seller can’t sell the security. Lock-in periods can cause liquidity risk in mutual funds like ELSS. Lock-in means you cannot exit the investment during the lock-in period.
ETFs can be bought and sold like stocks. ETFs may face liquidity risks. Sometimes you can’t redeem your investments when you need them due to a lack of buyers. Diversify your portfolio and choose your mutual funds carefully to avoid this.
Inflation risk is the possibility that the worth of your money slowly erodes and the value of long-term investments reduces. Because money market mutual fund returns are so low, they could be quickly outpaced by inflation over time. These mutual funds are most susceptible to inflation risk.
Socio-political risk refers to the likelihood that war, terrorist attacks, or political elections may have a detrimental influence on the market as a whole.
Changes in the foreign policies and economy in which the mutual fund has invested pose a risk. Certain legislative changes or economic volatility in the foreign nation could impact the mutual fund’s returns. This risk primarily affects international money.