What are the risks involved in mutual funds?

Mutual funds have turned out to be a great investment option over the past few years. However, there are some investors who are still not able to shift from the traditional investments like fixed deposits, reason being the risks associated to these investments.

Mutual funds are subject to market risk – please read the scheme related documents carefully

1.Market risk: Market risk is the risk related to those factors which may result in losses for investors due to a poor performance of the stock market. Your investments were worth 15 lakhs 6 months ago, then they declined to 12 lakhs and now they are up 20 lakhs.  The stock markets can make your heartbeat faster; this is what market risk is all about.  As a layman how do you mitigate this risk? Well before investing in equity related mutual funds look at the price to earnings ratio (P/E Ratio), if this ratio is high don’t invest in equities and shift to a safer avenue

2. Credit Risk:  Credit risk is related to debt mutual funds which mean that the issuer of the scheme is unable to make payment of principal and interest. Let’s say you lend money to your friend and he is unable to pay you the money back, you are exposed to credit risk. Debt instruments are always given a rating by rating agencies like CRISIL such as (AAA, AA+, AA) You should always do a detailed study about portfolio characteristics held by the debt mutual fund scheme and you must ensure that the fund manager invests in AAA rated securities. A Lower rated debt scheme (C, C-, D) are more exposed to credit risk. 

3. Interest rate risk:   Interest rates and prices of bond are inversely related. When interest rates go up, price of a bond falls. Similarly, when interest rates decrease, price of a bond hikes up. Debt funds of shorter maturity like liquid funds, short term funds etc are less prone to interest rate risk as compared to debt funds with longer maturity. 

4. Liquidity Risk:  In mutual funds, like ELSS (Equity Linked Saving Scheme) the lock-in period freezes your liquidity which results in liquidity risks.  Liquidity risk normally arises in close ended schemes, where there is less liquidity and you are forced to sell your fund at a discount. Hence it is advisable to invest only in open ended schemes which have a high amount of liquidity.

5. Inflation risk:  The reason most of us start investing is to earn returns and beat inflation. But at times our investments don’t fetch us enough returns to beat inflation. This is especially true in money market funds, where the returns are low and can easily be beaten by inflation.