Understanding market risk is important, but if you choose the asset class that best fits your goals, you can trust the fund manager to handle market risk for you or put money into a mutual fund.
The often-repeated statement is, “Investments in mutual funds are subject to market risks. Please read the offer document carefully before investing.” Investors in mutual funds tend to ignore this warning, just like they ignore the warnings on cigarette packs. But as a mutual fund investor, it’s important to be aware of the risks you’re taking.
The market risks referred to in the above statement are of two types:
- Risks that you can’t do anything about as an investor. Systematic risks could come from things like politics, changes in exchange rates, or even bad weather. Despite what you may have heard, it’s hard, if not impossible, to predict or avoid these.
- Diversification strategies can help you deal with the following risks: In a mutual fund, the fund manager takes care of these risks, but you should still be aware of them. We can put these risks into three main categories: business risk, concentration risk, and liquidity risk.
Business risk is like a sudden strike in the mutual funds for cars. Another case is when a business doesn’t make enough money. A fund manager can avoid this by putting money into a lot of different companies and industries.
When a mutual fund puts too much of its money into one stock or sector, this is called “concentration risk.” Concentration risk is a risk that comes with investing in a single sector, which is what sector funds do.
Liquidity risk happens when a fund can’t quickly turn its investments into cash, either because investors want their money back or because the portfolio needs to be rebalanced. This is a risk for mutual funds that buy small-cap stocks.
Now that you know, what can you do about it?
Be cautious when selecting mutual funds. Invest only in large, diversified equities funds. When investing in a specific sector or small/mid-cap funds, you must be fully aware of the dangers involved.
In our experience, mutual fund managers are adept at risk management. Investing in mutual funds carries the greatest risk for individual investors due to poor investment procedures. And there are numerous solutions available.
Reduce Risk by Minimizing Errors
Investing entails exposure to ‘risk’ by definition. Minimize risk as much as possible. The first step in mitigating risk is deciding to invest through mutual funds rather than stocks directly. You are saying, “Allow me to delegate the responsibility of investing to those who are more capable than I am and who do it full-time.”
But most people who invest in mutual funds still make a lot of simple mistakes. Let’s look at some common mistakes so you can avoid making them.
1. Investing with the hope of making a lot of money
In a previous section, we talked about what the expected long-term returns are for different types of assets. But investors continue to choose investments because they think they will get 40–50% returns. This is not going to happen, and if you try to get that return, you are likely to be misled into investing in funds that have had a temporary dip in performance.
Look at how much money has been made over at least 5 years. The best you can hope for with equity funds is a 2-3% outperformance, and the best you can hope for with debt funds is a 0.5-1% outperformance.
2. Putting money into investments without knowing what they are
You know that not every mutual fund is the same. Depending on which asset class and category of assets they invest in, they will get different returns and act in different ways. The return on debt funds is lower but more stable. The return on equity funds is higher, but it is more volatile.
Tax saving funds (ELSS) are similar to equity funds in that they have the same risk and return profile.
With what you learn in this course, you should be able to figure out how the returns from a certain type of mutual fund will change. You can review what you know here: How many different kinds of mutual funds exist?
Also, Read: How to decide which mutual fund is the best for your portfolio
3. Putting money into NFOs that are “at par” or funds with “low” NAV
Some investors think that the lower a fund’s Net Asset Value (NAV) is, the better deal it is. In other words, a fund with a NAV of Rs 20 is “cheaper” than one with a NAV of Rs 30. This belief may be a wrong way to use the principles of value investing in equity investing.
So, these investors often put Rs 10 into a New Fund Offering (NFO), thinking they are getting a good deal.
But from this course, you already know that it doesn’t matter if the NAV of a fund is high or low. In fact, older funds with a longer track record will always have a higher NAV than new funds with a lower NAV but no track record.
4. “Dividend” investing
Mutual funds advertise dividends. Some investors mistake greater dividends for excellent performance. Mutual funds declare dividends as book entries. Dividends reimburse capital, not interest. Dividends reduce the fund’s NAV. Tax-wise, a growth option where you withdraw money when you need it is better.
Understanding market risk is crucial, but if you choose the asset class that best suits your goals, you can trust the fund management to manage market risk.
Investors should focus on controllable factors:
- choosing the right mutual funds
- following the correct process for investing
- reviewing your investments every year
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