Why Are Mutual Funds Considered Risky Even When They Diversify Risk?

Mutual funds can help investors access the financial market's growth opportunities. They also seek to reduce risk through diversification and professional management.

Despite these advantages, mutual fund investments are not risk-free. Returns are not guaranteed and depend on market risk, liquidity risk, credit risk and other factors.

Read on to find out why mutual funds carry risk despite diversification and other mitigation measures.

• Table of contents

1. Why are mutual funds risky?
2. Types of risk in mutual fund
3. Tips to combat risks associated with mutual funds

Why are mutual funds risky?

Mutual funds, like any other market-based investment vehicle, are affected by volatility, economic conditions, government policies and other factors. These risks can affect returns and, in some cases, even lead to losses. However, by understanding these risks and choosing the right schemes for their investment goals, investors can build a strong portfolio that seeks to balance risk with reward potential.

Types of risk in mutual fund

• Market risk: Fluctuations in the prices of stocks and bonds based on market trends and investor sentiment can change the value of underlying assets in a mutual fund portfolio.
• Interest rate risk: Changes in the prevailing interest rates in the economy impact the value of fixed-income securities such as bonds. When interest rates rise, bond prices typically fall, and vice versa. This can also have an indirect effect on equity investments.
• Unsystematic risk: Unsystematic risk refers to an event specific to a company or sector. For example, a company's poor performance or a sector-wide downturn can negatively affect a mutual fund that heavily invests in that area. Diversification helps reduce this risk but does not eliminate it.
• Credit risk: Debt funds invest in bonds issued by governments and companies. There's a chance that the issuer might default on their repayment obligations, leading to potential losses for the fund and its investors.
• Management risk: The expertise of the fund manager plays a crucial role. Poor investment decisions or inability to adapt to changing market conditions can impact returns.
• Underperformance risk: Mutual funds may underperform their benchmarks or similar funds in the same category. Factors such as high fees, poor selection of securities, or unfavorable market conditions can contribute to this.
• Concentration risk: Some mutual funds may concentrate their investments in specific sectors, regions, or asset classes. This increases the risk of losses if those sectors or regions underperform or face adverse events.

Additionally, investments can face liquidity risk (difficulty in converting the investments to cash) and inflation risk (which can erode purchasing power).

Tips to combat risks associated with mutual funds

• Invest according to your risk tolerance: Choose a mutual fund category that aligns with your risk appetite. Aggressive investors may opt for equity funds with higher potential growth but also higher volatility. Conservative investors might prefer debt funds for relative stability and lower risk.
• Diversify within your portfolio: Invest in a mix of mutual fund categories – equity, debt, and hybrid – to spread risk across different asset classes. Within equity, too, you can diversify across sectors or market capitalizations to potentially mitigate concentration risk.
• Choose the right investment horizon: When investing in equity, a long investment horizon gives you more scope to weather market downturns and potentially optimize the benefit of compounding. Meanwhile, some debt funds may be better suited for short horizons as potential return may not keep pace with inflation.
• Choose high-quality debt instruments: Invest in debt mutual funds that focus on high-quality debt instruments issued by the government or top-rated companies. Also diversify across debt instruments with varying maturities – short, medium and long – to try to reduce the impact of interest rate risk.
• Consider a Systematic Investment Plan (SIP): Invest consistently through SIPs to potentially benefit from rupee-cost averaging. Rupee-cost averaging is an investment strategy where a fixed amount of money is regularly invested in a particular asset, regardless of market conditions. This approach aims to leverage market volatility by purchasing more units when prices are low and fewer units when prices are high. It typically reduces the per-unit cost of your investment, thereby potentially increasing gains.
• Research and choose wisely: Before investing, research the mutual fund's performance history, expense ratio, investment strategy, and the fund manager's track record.

Conclusion

Just like any other investment, mutual funds are subject to market risks. However, choosing the right scheme as per your risk tolerance and investment goals can improve your investing experience and help build a resilient portfolio. Diversification is essential for risk mitigation. Within mutual funds, try to diversify your portfolio across asset classes, durations, sectors and market capitalisations. 

FAQs

Why are mutual funds considered risky even when they diversify risk?
Mutual funds invest in a variety of financial securities, like equities, bonds, and other instruments. While diversification helps reduce certain risks, it does not eliminate them. Changes in the market prices of these assets affect the performance of mutual funds.

How do market fluctuations affect the risk of mutual funds?
Market fluctuations can significantly impact the performance of mutual funds, especially those invested in equity. During market downturns, the value of the fund's holdings may decrease, leading to potential losses for investors.

What role do interest rate changes play in the risk of mutual funds?
Interest rate changes can affect the performance of debt mutual funds that invest in fixed-income securities. When interest rates rise, the value of existing bonds typically falls, and vice versa. This can impact the portfolio's NAV.

Can sector-specific risks impact the performance of diversified mutual funds?
If a fund has a higher concentration in a particular sector or industry, underperformance in that sector can negatively impact the fund's returns.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.