Whenever talks of mutual fund take centre stage, most of us cast our mind to the television ads that read, “ Mutual fund investments are subject to market risks. Please read the offer document carefully before investing”. But not many pay attention to such warning. Any financial instrument does pose risk and mutual fund is no exception. There can be a number of risks ranging from geopolitical to business that may affect the performance of a particular fund. Even though risks are controlled by fund managers in charge of respective funds. But, one must know the risks involved as well as the solution to reduce the same. You can’t eliminate the risks as mutual funds are market-driven. So, you are left with the option to reduce the risks only. In this article, we will elaborate on the risks and the ways to reduce the same.
There are two types of risks, one is market risk and another is the series of your own mistakes that invite risks and lead to losses. Market risks, on which you do not have any control, are known as systematic risks that arise from unprecedented political movements, bad weather impacting agri and allied sector stocks, fluctuations in exchange rates and many more. These risks are further categorized into business risk, liquidity risk and concentration risk.
Business risk relates to events like employee strike, a decision by the government adversely impacting the growth of a particular sector, the poor performance of a company at different stages of a financial year, etc.
If the fund finds it impossible to quickly convert its investment into cash either due to investors’ redemption demand or as part the strategy to rebalance the portfolio, then it is called as liquidity risk. Mutual funds, which invest in small cap, generally face this type of risk.
When a mutual fund invest a large pool of money in a single stock or sector, then concentration risk comes to the picture.
You must be careful while choosing mutual funds as a weak selection can trouble you big time. Make sure you put your money on well-diversified equity funds. If you wish to invest in a specific sector and mid/small cap funds, then get acquainted with the related risks. Most of the risks, however, are committed by our own errors. And if we stop committing mistakes, the risks will start minimising. Here are some of the remedies to reduce the risks associated with mutual fund investments.
Go for fundamentals instead of steep returns
Most of us likes to rake in a big sum from mutual fund investments. Expectation of 50%-60% returns is something that drives the investment into mutual funds. And in a bid to get such return, most of the investors start searching for the funds that might shown remarkable performance. But, they fail to check whether the performance of the fund is consistently good or has happened in a particular quarter only. Small and mid cap funds generally exhibit such performance. Unaware of the weak fundamentals of such funds, individuals invest in them and end up losing more than they gain. So, you must not aim too high and instead look to pick the funds with strong fundamentals. Pick the fund on the basis of performance in 2-5 year period and a quarter to a year. Assessment of a fund will always be better if you choose a longer time frame as that will show the overall picture in terms of returns, downfall as well as the resilience of the funds.
Be aware of risk and return associated with underlying investments
You must be aware of the risk profile and return grade of various mutual fund investments. Risk and return differ among varied asset classes and categories. Equity funds aim to provide higher return but are quite volatile in nature, while debt funds ensure a low and steady flow of return. Tax-saving Equity Linked Saving Scheme (ELSS) offers return and involves risk equivalent to an equity fund. However, you can get tax exemption on holding ELSS for 3 years, which is the lock-in period of this investment. Knowledge of return and risk will help you choose the funds according to your taste and style.
Check track record and not NAV of fund
While choosing a mutual fund via New Fund Offering (NFO), keep an eye on its track record and not the NAV. One can be tempted to buy a mutual fund with a lower NAV and ignore the fund with strong tack record having higher NAV. Weak track record can dampen the returns on your chosen fund.
Now, you have got the details of risks involved and the necessary remedies to reduce the same. Use these solutions to good effect and enjoy your mutual fund journey.