Are Mutual Funds completely risk-free?
Created on 14 May 2022
Wraps up in 6 Min
Read by 4.5k people
Updated on 11 Sep 2022
Generally, when things go south in a marriage of two people, there’s at least some alimony involved. But what do 50 million Mutual Funds Investors get when the market hits rock bottom? Baba ji ka?
We end up spending on gold, real estate, and insurance without thinking about price drops or missed opportunities (as is the case of insurance). We never want to take chances in the stock market. However, we frequently take chances when it comes to SIP Mutual Funds. We invest, and even if we lose money, we continue to invest for the long run.
However, due to the variety of equities in a Mutual Fund's AUM, it has a lower risk than straight equity ownership. Basically, the fund managers in mutual funds divide your money among numerous firms based on the funds you've picked. Even if a few stocks do not perform well, they will have little impact on your portfolio. Thanks to diversification, the risk is reduced.
But because of this reduced risk, investors usually follow an "invest and forget" mentality with mutual funds. Top it off with the fact that the onus of capital allocation falls on the fund manager, and people truly believe that investment in mutual funds does not require any personal input from the investor themselves.
Risks involved in SIP and SWP Mutual Funds
When investing in a mutual fund, investors have two main concerns; whether they will be able to collect adequate capital gains without losing money and if the asset management organisation that manages the pooled assets is reliable.
For the latter, the Securities Exchange Bureau of India (SEBI), and the Association of Mutual Funds in India, oversee and supervise all domestically operated mutual funds. As far as the first worry is concerned, here is a list of what could hurt your MF portfolio.
1. Stock Market or Equity Risk
The money you put into an equity-based mutual fund is eventually invested in the shares of publicly traded firms. As a result, equity SIP mutual funds, or any fund having a portion of its assets invested in stocks, are exposed to the hazards of stock markets. It is also the risk posed by the market's volatility character, in which stock values fluctuate for a variety of causes. Foreign factors add to the volatility of shares, affecting the mutual funds associated with the said share.
2. Credit Hazard
All debt-based SWP and SIP Mutual Fund investors are exposed to this risk. Credit funds invest in debentures and bonds, which are fixed-income products. The government, companies, and various firms are usually the borrowers in the case of these securities, and the mutual fund is the lender. When a borrower or issuer takes out a loan, they commit to returning the principal and interest within a previously agreed-upon schedule.
3. Risk of Interest Rates
A risk linked with debt funds is interest rate risk. Bonds are exchanged in the same way that stocks are, and their prices fluctuate. The movement in bond markets is mostly influenced by the economy's interest rates. The link between the rate of interest and bond rates is inverse. This is because debt funds offer interest at an unchanged rate. So when the economy's interest rates go up, the borrowing associated with debt funds becomes less attractive due to comparatively lower interest rates, and vice-versa.
4. Risk of Inflation
Inflation is defined as an increase in prices as a result of a fall in the value of a country's currency. As the value of the currency decreases, the number of units of an investment instrument it can buy also falls.
Top considerations for evaluating mutual fund safety
Risk is only one of the few things that investors need to look out for when investing in mutual funds. Having discussed various risks above, these are the following factors that can help an investor decide whether or not a specific fund is suitable for their portfolio and if they should engage their capital in a fund.
A well-managed fund may produce investment income of up to 12%, roughly twice as much as typical financial vehicles such as fixed or recurring deposits. The primary goal of a mutual fund is to generate profits from the securities markets by earning significant returns. However, 12% is an average of sorts, as funds tied to specific sectors may perform better or worse than the market based on factors specific to that industry. So, check the industry/index your fund of choice is linked to in order to gauge its possible returns and invest accordingly.
2. Factor of Uncertainty
Because they account for unpredictability, mutual fund investments employing a systematic investment strategy (the popular one among owners) are safer. But what happens when the investor, for whatever reason, cannot contribute to the fund? Does the mutual fund forfeit the investors' deposits? Worry not, investors of mutual funds can suspend their SIP until they can resume paying again. The period and conditions of suspension vary based on the fund management organisation.
This makes mutual funds a better option for investing than a recurring or fixed deposit. The deposits with the banks get terminated in case a payment is missed.
3. There Is No Need For a Loan
Assume an investor has already contributed to a SIP mutual fund for 10 years and has reaped substantial capital gains. Now, they want to send their children abroad for higher education. An education loan taken for this purpose could burn a significant hole in the person's pocket with interest rates as high as 12 percent!
But, what if the investor didn't want to take a loan at all? All they'd have to do is liquidate the bond fund they'd been contributing to and utilise the capital gains (possibly as high as 12 percent), to pay for their children's education.
4. Tax Advantages
In comparison to other investment instruments, mutual funds are tax-efficient. Long and short-term returns are taxed differently; so investors should make sure they hold their investments for the appropriate durations to save money on tax. Furthermore, some mutual funds, such as the capital savings plan, or ELSS, have specific deductions under the tax law and are intended expressly for tax benefits.
The Bottom Line
Investment is always a game of risk, irrespective of the instrument chosen. Thinking of mutual funds; or any other investment class for that matter, as risk-free, could prove fatal to an investor's portfolio. The aforementioned risks apply to mutual funds and investors should perform their due diligence before investing in mutual funds, just as they would with shares.
You can invest in equity assets through mutual funds if you want greater returns. You can also invest in debt funds, which provide lower risk but fewer returns if you have a low-risk appetite but want to invest anyway. Furthermore, you may buy hybrid mutual funds to get a good balance of both.
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