After all, why is it said and heard again and again that mutual fund investments are subject to market risk? What are these market risks? A knowledgeable and smart investor collects all the information before investing and does all kinds of homework to determine the price of his security, yet remember that ultimately the market decides the price. Every investor should know that there is always a certain risk involved with any type of security in the ‘market’. You should also know that mutual funds are designed to minimize this risk as much as possible.
What is market risk?
Mutual funds invest in various securities and the nature of the securities depends on the objective of the fund.
For example, an equity or growth fund invests in various company stocks, while a liquid fund invests in Certificates of Deposit (CoD) and Commercial Paper (CP).
However, all these securities are traded in the market. Like the shares of the company are bought and sold through the stock exchange, which is part of the capital market.
Similarly, debt instruments such as government securities can be traded through a platform on a stock exchange or through special systems called NDS.
These act as markets for buying and selling securities and there is a great diversity of buyers and sellers. That is, the whole process of buying and selling, and pricing is done by the ‘market’.
Difficult to predict market direction
The price of any security is dependent on the ‘market forces’ and the market decides its direction on the basis of any news or activity, hence it becomes difficult to predict the direction of the market, short-term any stock or security. It is impossible to predict the price of. There are many factors and players influencing the direction of the market.
There are different types of market risk and they can be mitigated in certain ways.
Concentration Risk: This risk increases when you invest all your money in one sector or one stock or one asset.
Remedy: To stay away from concentration risk, you should try the weapon of diversification.
Interest Rate and Inflation Risk: This risk, called the silent killer, affects the value of your investment. If the rate of inflation is higher than your return, then you get negative returns and incur losses.
Remedy: One should invest in such instruments which get more return than inflation rate. One should build a portfolio by investing in bonds etc. with sectors (banks, NBFCs, real estate, autos) that are very likely to be affected by interest rate changes.
Currency Risk: These risks affect your rupee portfolio against the dollar. IT, pharma and auto subsidiaries are essentially export-oriented and benefit from a stronger dollar, while sectors such as capital goods, power and telecom are importers and benefit from a strengthening rupee.
Remedy: While building your portfolio, keep a mix of both dollar defensive and rupee defensive to hedge your risk.
Volatility Risk: Whether you are investing in bonds or equities, volatility doesn’t stop you. When you invest for the short-term, these risks are quite high.
Remedy: You can manage volatility by adopting a long term and systematic approach. Equity Fluctuations
becomes equal with longer duration. In addition, a systematic or phased approach helps to overcome volatility.
Liquidity Risk: This risk arises when the investor is unable to redeem his investment without any loss. In Mutual Funds, Equity-Linked Funds (ELSS) have a lock-in period of 3 years, as the risk remains high during this period.
Remedy: To maintain liquidity, some investment should be kept in instruments like liquid funds, bank FDs. In the case of stocks, when there is volatility in the market, then this problem becomes more serious. However, in normal market conditions, you can avoid this risk by sticking to low-impact-cost stocks.