Risk in Mutual Funds: Types, Factors & How to Manage It

March 4, 2025 by Anas in Uncategorized 0

I bet you might have heard this in your childhood while watching TV: “Mutual Funds are subject to market risks. Please read all related documents carefully before investing,” even when you were not knowledgeable about mutual funds. Like any other investment option, there are some inherent risk in mutual funds.

These risks are similar to those of a cricket batsman chasing a particular score on the field. To win the game, they choose aggressive shots that carry both the risks of dismissal and the rewards of hitting a boundary. In the same way, investors seeking higher returns must be well aware of the risks associated.

Mutual funds are the most sought-after and practical way of investing which benefits investors from its benefits like cost-averaging, diversification, and more while still bearing some sort of risks. Risk in mutual funds can be market fluctuations, liquidity, credit risks, and more. As an investor, what you can do to minimize these risks is to learn more about them to be on the safer side. Let’s dive into the blog to learn more about them.

What Makes Mutual Funds Risky?

The primary reason that makes mutual funds investment risky is that it allocates money in a variety of investment instruments such as equity, debt, bonds, gold, REITS, and more. And, the value of these investments keeps fluctuating over time due to a lot of factors and thus results in loss.

Owing to this volatility, the Net Asset Value (NAV) of investments comes down. In simple terms, NAV is the value of one unit in a mutual fund after deducting expenses. It shows how much your investment is worth at any time. Therefore, it becomes critical to identify the risk in mutual funds and invest in the most suitable ones.

Different Types Of Risk In Mutual Funds

Risk in mutual funds are of two types: systematic (market-wide) and unsystematic (specific to a company or industry). Systematic risk affects all investments, while unsystematic risk is tied to individual assets. Dive into our list below to explore the different types of risks associated with mutual funds.

1. Market Risks

It is a type of risk that may result in the investor’s loss due to the poor performance of the market. There are numerous factors that affect the market if you dig deeper into the details. Some of those factors include economic conditions, inflation, recession, natural disasters, government policies, interest rates, and more.

Market risks come into the category of systematic risk. In such a scenario, just diversifying your portfolio is not going to help. The only thing that you can do is wait for the right time for things to fall into place.

2. Liquidity Risks

Liquidity risk is the challenge of selling an investment quickly without losing its value. It can also occur when there are few buyers or low market demand. Mutual funds like the Equity Linked Saving Schemes (ELSS) scheme which comes with a 3-year lock-in period may cause liquidity problems.

Other than ELSS, Exchange Traded Funds (ETFs) also suffer from the same kind of problem. The best method to avoid liquidity problems is to have a diversified portfolio containing well-thought-out mutual funds.

3. Concentration Risks

Concentration usually means focusing on just one thing among many others. You all have heard the common investment adage – “Don’t put all your eggs in one basket” by experienced investors. Also, this phrase holds true in the world of investing.

Putting a considerable amount of money into just one particular scheme is never a good investment choice. You might book huge profits if lucky, if not, you might have to suffer a profound loss. Portfolio diversification is the best strategy to stay away from such risks.

4. Interest Rate Risks

The next risk in mutual funds is related to interest rate. Interest rates changes based on lender availability and borrower demand. Higher demand or lower credit supply often raises rates. They are inversely related to each other. Increasing the interest rate during the investment period might bring a reduction in the securities price.

For example, if someone invests Rs.100 at a fixed 5% interest rate for a certain period, changes in interest rates can affect the bond’s value. If rates rise to 6%, the bond’s fixed rate becomes less attractive, reducing its market value below Rs.100. On the other hand, if rates drop to 4%, the bond’s higher fixed rate makes it more valuable, allowing it to be sold above Rs.100. This shows how interest rate changes impact bond prices.

5. Credit Risks

Next is credit risks, which means that the scheme issuer is not able to pay what was promised as interest. Investment agencies are rated by rating agencies, and higher-rated firms typically offer lower returns, while lower-rated ones offer higher returns. Mutual funds, mainly debt funds suffer from this type of risk.

The fund managers have to include only investment-grade securities in debt funds.

However, at times, in order to earn better returns, they tend to include lower credit-rated securities increasing the credit risks of the portfolio. Therefore it is always advised to research the credit ratings of the debt mutual funds before actually investing.

6. Inflation Risks

Due to rising inflation rates, investors are losing their purchasing power. Most of the time, these risks affect investors a lot whenever their investments fail to keep up with the increasing rate of inflation. For instance, if the rate of inflation is 8% and the rate of returns is 12%, then the investors are left with only 4%.

7. Rebalancing Risks

Mutual funds are regularly rebalanced and monitored by fund managers. However, frequent reinvestments can sometimes lead to missing out on potential growth opportunities in the market.

Although there are multiple risks associated with mutual funds, but, investors can mitigate the same by smart investment planning.

Tips to Combat Mutual Fund Investment Risks

Listed below are a few tips that you can implement to effectively cushion the mutual fund risks. Understanding these tips will help you to protect your investment while steering away from mutual fund risks.

1. Build a portfolio that suits your risk profile

To reduce mutual fund risks, investors should choose a profile that aligns with their risk tolerance. Furthermore, they can also consider factors like age, financial situation, goals, and risk appetite. For example, low-risk investors with long-term goals may benefit from a balanced mix of debt and equity funds.

2. Invest through a Systematic Investment Plan (SIP)

The SIP approach of investment helps in spreading your overall risk effectively. Its features like rupee cost averaging and compounding benefits also reduce investment costs over time making it more efficient for investors.

3. Diversify your overall portfolio

To balance the portfolio’s risk-reward ratio effectively, investors must allocate their investment across multiple asset classes and securities such as stocks, debt, gold, bonds, and more. By keeping in mind the time horizon, risk appetite, and financial goals, investors can diversify their portfolios accordingly.

4. Investment through a Systematic Transfer Plan (STP)

This route of investment assists in distributing the risks of mutual fund investments over a period which further helps in reducing the average cost of investment. Inclusively, it assists investors in minimizing the impact of an overvalued market on their portfolio. Also, the process of STP allows investors to shift their investment from one fund to another (in the same Asset Management Company) helping them to combine their gains and reduce the risks associated with investing.

Conclusion

Managing these risks effectively is the critical step to achieving long-term financial goals through mutual funds investing. To do so, you can implement strategies like SIPs, diversification, STPs, and most importantly regular portfolio checks. These techniques of investing let you secure better returns while mitigating the risk in mutual funds and market volatility.

In addition to this, investors should also align their investments with risk tolerance and seek advice from experts like Wealth Redefine to get personalized financial solutions. In conclusion, a proactive approach to risk management makes sure that mutual fund investments are well-equipped to create consistent returns and steer away from potential market downturns.

Frequently Asked Questions on Types of Risk in Mutual Funds

Q 1- Is it risky to invest in mutual funds?
Ans- Investing in mutual funds comes with its inherent risks which can vary depending on your fund selection and market conditions. However, you can always conduct thorough research and consult with financial advisors to determine the risk level before investing.

Q 2- Are mutual funds safe to invest in the long term?
Ans- While comparing mutual funds with other investment options, it is generally accompanied by fewer risks. And, one should always make thoughtful investment decisions after considering all the pros and cons. Also, if you plan well for your long-term goal, then mutual funds are one of the best and most practical options to achieve the same.

Q 3- Can mutual funds go to zero?
Ans- Portfolio diversification aims to reduce the overall risk associated with mutual funds, but there is no guarantee against any kind of loss. However, the probability of a mutual fund’s value touching zero is negligible if well managed and diversified.

Q 4- What is the safest type of mutual fund?
Ans- Liquid and overnight funds are among the most secured mutual funds because of their short-term investment horizon and minimal risk exposure.

Q 5- What is the biggest problem with mutual funds?
Ans- One of the biggest problems of mutual fund investment is market risks. Their value can also fluctuate up or down just like stocks and bonds. Also, they have principal risk, which means that one can also lose their original investment amount.

Q 6- Is it normal to lose money in a mutual fund?
Ans- While mutual funds have great potential to make better returns, they can also lose money, especially in volatile categories. One must learn to balance the risk and reward before investing to stay safe financially.

Q 7- Are mutual funds better than Fixed Deposits (FDs)?
Ans- Taking tax efficiency into account, mutual funds are better than fixed deposits because of long-term capital gains savings, whereas on the other hand, FD interest rates are totally taxable.

Q 8-Is mutual fund tax-free?
Ans- Profits from mutual funds investment are known as ‘capital gains’. These gains are subject to tax. Therefore, investors should learn how their returns will be taxed in mutual funds.