How Mutual Funds Can Help You Mitigate Common Risks Associated With Investments
Jun 14, 2019

Author: Divya Grover

(Image Source: photo created by mindandi - www.freepik.com )

The latest AMFI data on SIP flow shows that the SIP contribution in the month of May 2019 was Rs 8,183 crore, lower than Rs 8,283 collected in April 2019. Though the fall is marginal, the reason behind it could be that the investors are wary after the recent spate of downgrades and defaults in the NBFC sector.

The crisis affected mutual fund investors because fund houses with exposure to debt papers of such companies had to write-off their investments. This meant that the NAV of the scheme dropped to the extent of write-offs. The fund houses also had to face redemption pressure as a result and they were forced to liquidate high quality papers to meet the redemptions.

However, one good thing did come out of the debacle -- it broke the misperception many investors had that debt funds are safe.

The fact is no investment is safe though the risk varies from one investment to another. Higher the returns you expect, the higher is the risk involved.

This highlights that while making investment decisions, one should not only look at the expected returns, but also the risk involved with such investment.

Mutual fund investment can help you minimise the various risks associated with investments. However, do note that investments in mutual funds are not risk free.

Here is how you can mitigate some of the investment related risk when you invest in mutual funds:

  1. Inflation risk

    If the value of your investment does not grow at a higher rate than inflation, it can erode the purchasing power of your money. With lower inflation-adjusted returns, you will be able to purchase fewer goods and services with the money that you have.

    Therefore, you should invest in assets which will appreciate your wealth over time and thereby counter inflation. For this purpose diversified equity funds would be a better option as compared to debt funds. Equity funds have the potential to generate higher returns over the long-term.

    [Read: The Good, Bad, And Ugly Of Inflation]

  2. Business risk

    It refers to the risk that company/business you have invested in may fail to achieve their target, suffer losses, bankruptcy, etc., due to any internal or external factors. If you invest in just one company/business, your risk will be higher due to the concentration of your investment and consequently your loss could be higher too.

    As mutual fund invests in the stocks of many companies in one scheme, it helps in diversification of your investment. It is unlikely that all the stocks of the scheme will underperform at the same time. Thus your losses reduce if the stocks in the scheme underperform, however, your profits will be limited too.

    [Read: 5 easy steps to select a diversified equity mutual fund]

  3. Credit risk

    This is a major cause of concern for debt investors these days. People invest in debt instruments with the hope of getting their principal amount back along with interest on the day of maturity of the instrument. If the company delays or defaults in the payment, investors suffer credit risk.

    Generally, debts with credit risk offer higher interest rate to compensate investors for the risk they undertake. To manage credit risk, you can opt for gilt funds; they invest in government securities which are backed by sovereign guarantee. Do note that while government securities are safer, the interest rate they offer will be lower.

    In addition, invest only in debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

    [Read: Is Your Investment In Debt Mutual Fund At Risk?]

  4. Interest rate risk

    Whenever there is a change in policy rate by the RBI, the interest rate of fixed income securities undergoes changes too. The value of debt securities is inversely related to the interest rate. Therefore, the value of securities will increase or decrease in line with change in interest rate.

    Interest rates fluctuate more if the duration of the debt instrument is higher. If you want to invest in debt funds with low interest rate fluctuations, you can opt for short-duration debts such as liquid/ overnight funds, ultra-short and low duration funds, money market funds, and so on.

  5. Liquidity risk

    This risk prevents you from redeeming your investment whenever you want to. Some investment avenues come with a lock-in period and redemption during that period is not allowed. Even if it is allowed, you may have to suffer capital loss. If during the course of investing you discover that the selected avenue is underperforming or is not suitable for your needs, you will have no choice but to stick with it until the completion of the lock-in period.

    Instead of investing in avenues with lock-in period, you can invest in open-ended mutual fund schemes. Open-ended mutual funds allow you to choose funds from different categories and sub-categories so that you can select funds based on your needs. It also allows you to invest regularly in a systematic manner.

    [Read: Should You Avoid Mutual Funds With a Lock-In Period?]

To conclude

Investments will always be prone to risk due to various factors like performance of the economy, fiscal and monetary policy changes, political changes, and so on. While there will always be volatility in the market, one can reduce its impact by selecting the right mutual funds after evaluating your needs and staying invested for long-term as the impact of volatility is higher in the short-term.

The risks associated with investments are mentioned in the offer documents, brochure, and other sources of product detail. Go through the details carefully to understand the risk involved before making any investment decision.

If you have any difficulties in understanding the risk associated with investment, it would be best to consult with an investment adviser.

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