Equity funds and debt funds are two types of mutual funds that invest in different types of securities. Equity funds invest in stocks, while debt funds, invest in bonds. While both types of funds carry some level of risk, the specific risks can vary.
In this article, we’ll compare the risks associated with equity funds & debt funds to help investors better understand the differences and make informed investment decisions.
There are many different types of risk that 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.
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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:
- 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.
- Interest Rates: Changes in interest rates can impact the value of bonds held in a mutual fund’s portfolio, as well as the earnings of companies whose stocks are held in the fund.
- 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.
- 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.
- 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.
- Stock market crashes: If the stock market as a whole declines significantly, the value of the stocks held in a mutual fund’s portfolio could also 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 experiences financial difficulties and is unable to make the required debt payments, the value of the bond will 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.
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, can be achieved by investing in a variety of different funds that hold a range 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 evaluating mutual fund investments, it’s important for investors to carefully review the fund’s prospectus & performance history. The prospectus is a legal document that provides detailed information about a mutual fund, including its investment objectives, risks, fees, & holdings.
Reviewing the prospectus can help investors understand the specific risks associated with a mutual fund and how it is managed.
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.
