Mutual funds are subject to market risk: this is a line we hear in every commercial by mutual funds.
The first thing to understand is, what is ‘risk’?
There are numerous definitions of risk.
Something all investors must be aware of is that different mutual funds have different kinds of risk and amounts of risk associated with them.
One easy way to think about it in the context of mutual funds is the chance of losing your investment money or a part of it.
Risk does not mean only your money becoming Rs 0. It can also refer to a smaller loss in value — like Rs 1 lakh invested falling down and becoming Rs 80,000.
This is just one type. There are other kinds of risk too.
Risk in equity mutual funds can be understood relatively easily — they are the same as that of stocks.
Why? Because equity mutual funds invest in stocks.
As discussed earlier, usually (though, not always), bigger companies’ stocks are lower in risk compared to smaller companies.
So, large-cap mutual funds are lower risk than mid-cap funds, and mid-caps are in turn lower risk when compared to small-caps.
In the world of stocks and equity mutual funds, volatility is known and well-accepted. Seeing your investments in the red is not uncommon, it is a part of investing in stocks and equity.
Risk does not necessarily mean that you lose money.
It could also mean that the returns are lower than expectations or benchmarks.
Risk is a bit more difficult to understand in the case of debt funds.
Equity mutual funds go up and down all the time. So people tend to be reminded of the risks very often.
Most popular debt funds do not go up and down frequently.
This is fine — they are far lower risk than equity mutual funds.
But, this does not mean they cannot go down. This is the part where investors are caught off guard.
Most debt funds have remained stable for long periods of time — and that’s great.
But some of them, especially the ones that give higher returns can give lower/negative returns in rare events.
Investors should be mindful of that while choosing debt funds to invest in.
One easy way to understand risk is to think about the risk associated with the assets the mutual fund invests in.
Equity mutual funds invest in stocks. So when you invest in equity mutual funds, you need to be aware of the same risks that are associated with stocks.
Likewise, debt mutual funds invest in fixed-income securities (bonds, etc). So you need to be aware of the same risks.
There is a difference though.
Mutual funds almost always invest in a large number of assets.
Equity mutual funds usually invest in over 50 stocks. Similarly, debt mutual funds invest in many securities.
This results in diversification.
Diversification results in a reduction of risk as the threat of something wrong happening to one stock or asset does not affect the entire mutual fund.
The interesting thing about risk is, the real risk is many times a surprise — it may not be something we were thinking about.
For example, you might plan for risks like market conditions and chances of a loss. And that might work out.
But when you want to take out your money, your own device (smartphone or laptop) may stop working causing you a delay in taking out money.
Or, let’s say there may be problems with the bank account where you have withdrawn your money that makes it difficult for you to access your money.
Those are very different kinds of risks that may affect your investments.
It’s impossible to factor in all risks on earth. But we should always aim to cover as many risks as possible.
