Why mutual funds are subject to market risk?

Everyone wants to generate capital appreciation with mutual funds but not one wants to understand the risks associated with these market linked schemes. Mutual funds like equity funds have outperformed most conventional investment avenues like PPFs and bank FDs in the past. However, they aren’t a risk free investment and one may even have to face losses in the short term. Mutual funds invest in a diversified portfolio of securities to mitigate investment risk and optimize returns. But that doesn’t make them a risk free investment. Although mutual funds try to offer risk adjusted returns and also offer active risk management by hiring expert fund managers, there are a few risks associated with them which investors should be aware of.

What makes mutual funds risky?

As mentioned earlier, mutual funds can be an excellent tool for targeting one’s both short term and long term financial goals. However, one must not overlook the dangers that are associated with mutual fund investments. Mutual funds invest across various asset classes and money market instruments like equity, debt, government securities, corporate bonds, etc. The performance of these underlying securities may fluctuate depending on various factors and this will cause a direct impact on the scheme’s market performance. Hence, it is better to understand the risk associated with the underlying securities of a mutual fund portfolio and invest accordingly.

So, when the markets are volatile and mutual fund schemes are underperformance, the NAV (Net Asset Value) which is the market value of that mutual fund will go down. This will directly impact an investor’s portfolio and they will have to suffer losses.

What is market risk?

Now if you have seen a mutual fund advertisement you have heard the disclaimer: “Mutual fund investments are subject to market risk”. What exactly is this market risk?

A market risk is a type of investment risk where a retail mutual fund investor can face losses if the markets turn volatile. Some of the generic factors that can affect market are natural calamities, political unrest, inflation, etc. The most recent example is the ongoing coronavirus pandemic that affected global economies and markets. A lot of people panic when markets turn volatile and try to redeem all their investments. An ideal thing to do at this point would be to remain invested till the markets normalize. Remember that even in the past several factors have led to poor market performance but eventually, the markets have normalized and delivered decent returns.

How to deal with market risk?

Investors may not be aware but with SIP they can actually benefit from falling markets. Systematic Investment Plan is an easy and convenient way of investing in mutual funds. Once you decide how much you want to invest in mutual funds regularly, all you have to do is automate transactions and the SIP sum will be automatically debited from the investor’s savings account and investors receive units in quantum with the existing NAV. As the NAV is low in volatile markets, investors receive more units. Similarly, when the markets are high and so is the fund’s NAV investors receive lesser units. This is referred to as rupee cost averaging, which averages the purchase cost and investors receive more units in the long run.

Investors may also refer to SIP calculator, a free online tool where one can know how much returns they will earn at the end of their SIP investing journey.

Predicting the markets is almost impossible but if the performance of your mutual fund scheme goes down due to any reason, make sure that you remain invested rather than letting your emotions getting in the way.