Understanding the Nature of Risk in Mutual Funds

Investing in mutual fund are subject to market risks. The only thing is that different mutual funds bring different levels of risk. These investment vehicles pool funds from several like-minded investors to invest in a diversified portfolio of assets such as equity, debt, gold etc. Further, they come in various types and each fund has a different level of risk associated with it.

Equity Mutual funds mainly invest in stocks and has the potential of high returns compared to other asset classes, but at the same time come with higher risk. Most people are unaware of the fact that within equity funds, there are different funds that have different levels of risk, for example, large cap funds that invest minimum 80% of the portfolio in top 100 companies by market capitalisation listed on stock exchange making them relatively less riskier compared to mid cap and small cap. Other Equity mutual funds like Thematic funds that invest in stocks tied to a specific theme such as technology, healthcare, or, Sectoral funds that invest in a specific-sector have relatively higher volatility whereas funds such as large cap funds, Dividend yield funds tend to be relatively stable over the long term.

On the other hand, Debt Mutual Funds invest in fixed-income securities like corporate bonds, government securities, etc, and generally carry lower risk than equity funds, offering stable returns. Within Debt mutual fund also different levels of risk exist. For example, Credit fund contains higher credit risk while funds like G-Sec or corporate bond might have higher exposure to long duration or interest rate risk.

Another mixed category of mutual funds collectively called Hybrid Fund invests in a combination of equity and debt mutual funds offering a balanced approach. This mutual fund category aims to achieve a balance between risk and return making them suitable for investors who are moderate risk-takers. One example of a hybrid fund is a Balanced advantage fund.

Mitigating Risk through SIP for long-term

A Systematic Investment Plan (SIP) is one method that helps mitigate risk associated with mutual funds. This plan allows you to consistently invest a certain amount in a mutual fund scheme regardless of market conditions. Through regular investments, SIP promotes disciplined investing and helps navigate market volatility through rupee cost averaging and power of compounding. One buys more units of a mutual fund when the prices are low and less units when the prices are high, this investor behaviour helps average out the cost per unit. This phenomenon is referred to as Rupee cost-averaging. Additionally, SIP also has the potential to improve your returns overtime through compounding as not just your initial investment earns returns but also your returns have the ability to generate more returns.

Reducing Risk Through Diversification

Another proven way to minimise risk associated with mutual funds is diversification. By investing across asset classes such as stocks, bonds and other securities, you reduce the risk associated with poor performance of any one asset class as it is balanced by the better performance of others. One way to diversify the investment portfolio is by investing in an equity mutual fund category known as Multi-Asset Fund that primarily invests in at least three asset classes such as equity, debt, gold or real estate, with minimum 10% in each asset class.

Myth vs. Reality: Exposing Common Misunderstandings

A lot of new investors often come across various myths associated to mutual funds. Let’s debug all one by one.

Myth 1: Mutual Funds Are Risky

Not all mutual funds contain the same level of risk. As discussed previously there are various types of mutual funds and each with different risk-level. By selecting the right type of mutual fund that corresponds with the risk tolerance of the investor, investors can minimise their investment risk.

Myth 2: All funds offer Higher Returns

There is a belief that all mutual funds offer high returns, but the reality is that returns depend on various factors such as type of mutual fund you choose to invest in, the tenure and amount of your investment, the prevailing market conditions and various other parameters. While equity Mutual Funds have the potential for high returns they also come with higher risk, whereas Mutual Funds which invest in fixed income security generally offer more stable but lower returns. However, they also contain relatively lower risk. It is important for investors to understand the various types of mutual funds and choose the one that is suitable to their financial goals and their risk tolerance. One must note that short term investments in mutual funds generally do not guarantee higher returns.

Myth 3: Mutual Funds Are Only for Financial Experts

Mutual Funds are designed to be accessible to all types of investors including those who have limited financial knowledge. Experienced professionals in the field such as a Mutual Fund Advisor make mutual Fund investing a convenient and effective investment option for both beginner as well as experienced investors.

Myth 4: Money Cannot Be Withdrawn Easily from Mutual Funds

There is a myth that Mutual funds are not easy to liquidate. While some Mutual Funds may have restrictions or penalties (when withdrawn earlier), investors can easily redeem their investments from most of the mutual funds as and whenever needed. Once redemption request is put, it normally takes T+3 days for funds to reflect in the investors bank account.

Myth 5: Mutual Fund does not Save Tax

A category of equity mutual funds called as Equity-linked Savings Scheme or ELSS allows one to save tax up to Rs. 1.5 lakh in a financial year as per Section 80C of the Income Tax Act. However, the only point to note is that once money is invested in ELSS, it has a lock-in period of 3 years during which money cannot be redeemed.

Risk Mitigation

While risk is always associated with returns, investors can follow various approaches for risk mitigation. The first approach is following an asset allocation strategy which helps in diversification. Second, can be following a systematic approach to investing. Experienced investors may also evaluate risk-adjusted returns for their systematic investments by calculating parameters such as Treynor ratio and Sharpe ratio. Further, by using the benefits of SIP, SWP (Systematic Withdrawal Plan) and STP (Systematic Transfer Plan) investors can make well-informed decisions and use mutual funds to create wealth over time. In short, it can be said that mutual funds are versatile and flexible options designed to suit investors with different financial goals and risk-taking capacities.