Understanding Risk of Mutual Fund Investing

Equity funds and debt funds represent two distinct categories of mutual funds that allocate investments in varying securities. Equity funds primarily focus on stocks, whereas debt funds center their investments on bonds. Despite both fund types entailing a degree of risk, the specific risks associated with each differ.

This comprehensive article aims to compare and contrast the risks associated with equity funds and debt funds, facilitating a deeper understanding for investors to make well-informed decisions when it comes to their investments.

An array of risks can impact investments, including:

Market risk

Main risks of mutual funds is market risk, which is the probability that the value of the securities in the fund's portfolio will decline. This can happen due to a variety of factors, such as economic downturns, changes in interest rates, or political instability.

There are many factors that can impact the value of securities held in a mutual fund's portfolio. Some of the most common factors include:

1. Economic Conditions: Changes in the overall economy, such as GDP growth or unemployment rates, can impact the performance of the securities in a mutual fund's portfolio. Global economic activity is experiencing a broad-based and sharper-than-expected slowdown, with inflation higher than seen in several decades.
2. Interest Rates: Shifts in interest rates can affect the value of bonds held within a mutual fund's portfolio, as well as the earnings of companies whose stocks are part of the fund.
3. Company-specific factors: The performance & financial health of the companies whose stocks are held in a mutual fund's portfolio can impact the value of those stocks.
4. Market Sentiment: Investor sentiment, or the overall attitude of investors towards the market, can impact the value of the securities. If investors become more risk-averse or lose confidence in the market, the value of the securities held in a mutual fund's portfolio could decline.
5. Political & Regulatory Factors: Political events and changes in government policies and regulations can also impact the value of securities held in a mutual fund's portfolio.
6. Stock market crashes: In the event of a significant decline in the overall stock market, the value of stocks held within a mutual fund's portfolio may also experience a decline.

Default risk or Credit Risk

Default risk, also known as credit risk, is the risk that a borrower will default on a debt, causing the value of the investment to decline. This is a particularly relevant risk for investments in bonds, as the value of a bond is directly tied to the creditworthiness of the issuer.

If the issuer encounters financial difficulties and becomes unable to meet the required debt payments, the value of the bond will experience a decline.

Default risk can also impact investments in stocks, although to a lesser extent. If a company whose stocks are held in an investment portfolio experiences financial difficulties, the value of those stocks could decline.

Example of Default Risk:

Satyam Computer Services was an Indian multinational company that provided IT services and consulting. In 2009, it was revealed that the company's founder & CEO, had been engaging in accounting fraud, causing the company's stock price to plummet and leading to the company's bankruptcy.

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This event represents an example of default risk, as the company's financial difficulties and subsequent bankruptcy caused the value of its stocks to decline. Investors who held Satyam stocks suffered losses as a result of the company's default.

Dewan Housing Finance Corporation Limited (DHFL), is an Indian housing finance company. In 2019, the company defaulted on its debt payments, causing its credit rating to be downgraded & leading to financial difficulties.

The company's default on its debt obligations represents an example of default risk, as the event caused the value of its bonds to decline.

Investors who held DHFL bonds suffered losses as a result of the company's default.

Additionally, the value of DHFL's stocks declined as a result of the company's financial difficulties and default on its debt payments.

If a mutual fund's portfolio contains stocks or bonds that suffer losses due to default risk, it could impact the fund's net asset value (NAV).

Liquidity Risk

Liquidity risk is the risk that an investment cannot be sold quickly enough to avoid a loss.

This risk is particularly relevant for investments in illiquid assets, such as real estate or private company stocks, which may be difficult to sell in a timely manner.

For mutual funds, liquidity risk can also be an issue if the fund holds a large number of illiquid stocks.

If investors try to sell their shares in the mutual fund and the fund does not have sufficient cash or liquid securities to meet the redemption request.

It could lead to delays in selling the fund's holdings & potentially result in losses for the fund & its investors.

To mitigate liquidity risk, mutual funds may hold a portion of their assets in cash or highly liquid stocks.

Inflation Risk

Inflation risk is a potential concern for mutual fund investors because it can impact the purchasing power of the returns generated by the fund.

If the cost of goods & services increases over time due to inflation, the value of the fund's returns in terms of purchasing power may decline.

Managing risk in mutual fund investing

For mutual fund investors, diversification also called Asset Allocation.

This strategy involves investing in a diverse range of funds that hold various types of securities, such as stocks, bonds, and cash.

By spreading investments across different types of funds, investors can potentially reduce the impact of market fluctuations or changes in the performance of any one security on their portfolio.

When assessing mutual fund investments, it is crucial for investors to conduct a thorough review of the fund's prospectus and performance history. The prospectus serves as a legal document that furnishes detailed information about the mutual fund, encompassing its investment objectives, associated risks, fees, and holdings.

Working with a financial advisor can be a helpful way for investors to manage the risks associated with mutual fund investing.

A financial advisor can provide guidance on investment strategies & help investors choose mutual funds that align with their financial goals & risk tolerance.

VI. Conclusion

Understanding and managing risk is an important aspect of mutual fund investing. While mutual funds can offer the potential for returns, they also carry some level of risk, including market risk, default risk, liquidity risk, interest rate risk, and inflation risk.

It's important for investors to carefully consider the risks of any mutual fund before investing and to choose investments that align with their financial goals & risk tolerance.