Myth buster: Are all mutual funds equally risky?

Mutual funds can be an affordable and convenient way to invest in the financial markets, making wealth-creation potential accessible to many.

However, the volatility associated with the financial market means that mutual fund returns are not guaranteed or fixed. As a result, some potential investors shy away from mutual funds, believing that all schemes are highly risky. Consequently, they may miss out on the superior return potential over long term provided by these funds in comparison to traditional savings avenues.

However, there are multiple mutual fund schemes suiting different risk appetites or risk tolerance levels, from low to very high. Broadly, debt mutual funds, which invest in fixed-income securities, typically entail low/low-to-moderate risk, while equity mutual funds (which invest in company stocks) carry high or very high risk.

Let’s explore what contributes to risk in mutual funds and the risk levels of different mutual fund categories. This will help you understand what type of scheme may suit your risk appetite and how you can make informed decisions when choosing where to invest your hard-earned money.

• Table of contents

1. What is a mutual fund?
2. What is investment risk?
3. The different types of investment risk
4. Risk spectrum of mutual funds
5. Mutual fund categories as per risk levels

What is a mutual fund

Let's start by understanding what a mutual fund is. A mutual fund is a type of investment vehicle that pools money from several investors. This money is used to buy a diversified portfolio of stocks, bonds, or other securities. Every investor in a mutual fund holds units, which correspond to a share of the fund's total assets. Mutual funds are managed by professional fund managers, whose job is to decide where to invest the money to potentially achieve the fund's objectives. The main advantage of mutual funds is that they offer small investors access to a diversified portfolio, which can help spread out risk. But remember, while mutual funds can reduce risk through diversification, they do not eliminate it entirely.

What is investment risk? is investment risk?

Mutual fund risk or investment risk is the possibility that the returns on an investment will be different from what you expected or projected. Risk is usually spoken of in the context of a negative outcome – the possibility of losing some or all of your invested money or earning lower returns than expected.

It’s important to recognise that all investments come with some level of risk. This risk arises from various factors such as market fluctuations, economic changes, and interest rate movements.

For example, if you invest in a stock, there's always a chance that the price of the stock will go down. Similarly, with mutual funds, the value of the units you hold can go up or down depending on the performance of the securities in the fund’s portfolio.

The different types of investment risk

Now, let’s take a closer look at the different types of risks associated with mutual funds. Understanding these risks can enable you to make more informed investment choices.

• Market risk: Market risk is the potential for investment losses due to fluctuations in overall market conditions, such as changes in interest rates, economic downturns, or geopolitical events.
• Credit risk: This applies mainly to mutual funds that invest in bonds. It’s the risk that a bond issuer will default on their payments, which could lead to a loss in the mutual fund's value.
• Interest rate risk: This is the risk that changes in interest rates will affect the value of the mutual fund. Generally, when interest rates rise, the value of bonds falls, which can impact debt mutual funds negatively.
• Liquidity risk: Liquidity risk refers to the risk that the mutual fund might not be able to sell its investments quickly enough to meet redemption requests from investors.
• Inflation risk: This is the risk that the returns from your investment will not keep pace with inflation, effectively reducing your purchasing power.
• Reinvestment risk: This is the risk that income or returns from a mutual fund scheme may be reinvested at a lower rate than expected, impacting overall return potential.

Risk spectrum of mutual funds

To make it easier for investors to understand the level of risk associated with different mutual funds, the Securities and Exchange Board of India (SEBI) has introduced the concept of the “Risk-o-meter”. The Risk-o-meter is a tool that is used to classify mutual funds according to their risk level. This level can range from low to very high. A Risk-o-meter makes it simpler for investors to understand how much risk they are taking on. Here are the different levels in a Risk-o-meter.

• Low risk
• Low to moderate risk
• Moderate risk
• Moderately high risk
• High risk
• Very high risk

Mutual fund categories as per risk levels

Let’s now explore the various categories of mutual funds and how they are measured in terms of risk.

• 1. Debt funds (Low to Moderately High Risk): Debt funds invest in bonds and other fixed-income securities. They are generally considered stable than equity funds but come with their own risks, like interest rate risk, credit and duration risk.
• 2. Hybrid Funds (Low/Moderate to Very High Risk): Hybrid funds invest in a mix of stocks and bonds. There are several hybrid mutual fund categories, each having a different ratio of bonds and stocks. A hybrid fund with more stocks is riskier than one with more bonds.
• 3. Equity funds (High or Very High Risk): These funds invest primarily in stocks. Because stock prices can be volatile, equity funds tend to be riskier than other types of mutual funds. However, they also provide the opportunity to earn higher returns over the long term. Within equity funds too, schemes that invest chiefly in large cap companies can be less risky than those investing in mid or small cap stocks.
• 4. Sectoral/Thematic funds (Very High Risk): These funds focus on specific sectors, such as technology or healthcare. They are riskier because they depend heavily on the performance of a single sector.

For equity funds, a long investment horizon is recommended because the markets can be highly volatile in the short term but have historically stabilised over longer horizons (past performance may or may not be sustained in the future).

A long horizon allows the investment to tide over temporary volatilities and potentially build wealth over time. Moreover, across the risk spectrum, mutual funds seek to mitigate risk by diversifying across multiple securities. Moreover, fund managers (who manage the scheme) seek to make strategic investment decisions to balance risk and reward potential.

Conclusion

Not all mutual funds are equally risky, and the level of risk that a scheme entail depends on the mutual fund category and the assets it invests in. Understanding the different types of risks and how they apply to various mutual fund categories is essential for making informed investment decisions. When choosing a mutual fund, consider your own risk tolerance, financial goals, and investment horizon.

Always remember that higher risk typically means higher return potential and vice versa. By referring to the Scheme Information Document and the Risk-o-meter, you can understand the nature of different mutual funds and navigate the world of mutual fund investing with more clarity and confidence.

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