When you invest in mutual funds, the risks involved are essentially the same as when you invest in any other investment option: the value of the investment may decrease and is subject to external risks over which you may have no control. However, with the wide variety of options available, the right combination of mutual funds can definitely help you manage risk really well. By understanding what the relevant risks are, you can be better informed and can conduct better research on which funds suit you and how you can invest intelligently to mitigate the risks.
Risks of investing in mutual funds broadly include:
- Macroeconomic risks
- Liquidity risk
- Credit risk
- Interest risk
- Investor biases, including:
- Over diversification
- Mismatched risk profile
- Risk of market timing
These are risks that impact the entire economy; for example, a shortage in oil supply leading to rising commodity costs, causing a dependent company to have decreasing profits or falling sales. The impact specifically on equity mutual funds is decreasing share prices of companies in a mutual fund portfolio leading to a decrease in the value of the fund (NAV). Inflationary pressures are generally accompanied by rising interest rates, which also affect bond funds as bond prices decline when interest rates increase.
Liquidity is the ability to buy or sell any investment easily. Funds are vulnerable to liquidity risk if the fund manager’s strategy has not allocated enough cash to handle expected and at times even unexpected fund sales (redemptions).
This is a risk specific to companies who have issued debt. Their credit is deemed risky in situations of weak economic growth, or where they are reliant on future earnings to service interest or capital repayments – any change to potential future earnings will affect their ability to pay. This situation would result in falling investment values, which in turn, will have an impact on the value of any fund that holds them. In equity investments, if a company is deemed to have a high credit risk, the value of the company’s share price will go down.
Interest rate risk
In a falling interest rate environment, equities tend to rise as a result of the movement of money out of bonds and into equities. Investors do this to capture better returns than bond investments. If interest rates are falling, coupon (interest) payments may be lower, so bonds are a less attractive investment. However, the reverse is also true and in rising interest rate environment, investors may choose bonds over equities.
Investor bias is any pre-existing bias that may influence investors to make an incorrect investment decision. It is generally referred to as the type of action that can cause you to buy or sell at the wrong time, or invest wrongly due to behavioral reasons. Some common types of investor biases are mentioned below:
- Sentiment oriented market timing is the attempt to time buying or selling into or out of a fund to capture the best possible value points, typically as a reaction to popular market sentiment. If adverse market conditions cause the value of your investment in mutual funds to decrease in value, you tend to feel stressed and panic. You also notice others in a similar position to you panicking and selling their investments off. However, stay invested for the long term to beat volatility in the fund, especially if your considered time horizon still has some time to go.
- Herding: The idea above where investors tend to do what others around them do, is also known as herding. This is because it makes one feels safe (part of being a herd). In fact, in times of market volatility, going against the grain and doing the exact opposite of popular opinion can lead to amazing results over the long term- Buying more when markets fall (even though emotionally you may be feeling sad like others around you) and cashing out when markets rise (even though your heightened spirits make you want to do otherwise).
- Confirmation bias: Investors sometimes have a preconceived notion of what’s right and what’s wrong, and the moment they find another person saying something similar or taking a similar decision, it tends to confirm what they had in their mind, leading to incorrect decisions being taken. Hence, it is important to think your decisions through after having considered all relevant facts and figures, and not be impulsive about it.
- Loss aversion: The human reaction to a similar level of gain or loss is not equal. In fact, a lot of research on this subject reveals that people tend to feel the pain of losing Rs 100 twice or more than the joy from finding Rs 100 unexpectedly. This basically means that people tend to do things to avoid making a loss rather than aiming to make gains. When it comes to investing, this idea is visible when we see people over-diversifying their investments across many similar mutual funds, thereby losing the real advantage behind investing right. This idea is also reflected in people ‘thinking’ that they will do the right things- for eg, buy more when the market falls or sell out when the market rises and their investment reaches a desired level, but ‘doing’ the exact opposite of this.
- Self serving bias: Investors may have made an investment in a mutual fund of their choice, and may have made tremendous returns in less than 6 months. This makes them feel confident that they are great investors and can beat the market easily. They end up underestimating the impact of external factors when they ‘win’ and overestimating ‘what they did’ to make the gains they made. Hence, they suffer from the self serving bias- which suggests that the good that happens is ‘because of me’ and the bad that happens is ‘because of something or somebody else’.
- Choice paralysis: In today’s world, we all like to have choices and the world of mutual funds offers us plenty of those, no matter what kind of investments one wants to make. However, choice also leads to paralysis as instead of thinking a decision through, when faced with many choices, you may simply delay making the choice to avoid tough decision making.
- Recency bias: Mutual fund investors often believe that what happened will repeat itself again. This is why the famous saying goes “past performance is no guarantee of future results”. Instead, most investors tend to go with top-10 performing funds in the last year or so, and make decisions based on this oversimplified assumption that these funds will give them high returns again. There is enough evidence to suggest this does not always happen. This is why experts recommend not just considering recent performance, but also many other factors before making an investment decision.
- Mutual funds are as safe as any other investment instrument.
- The risks in mutual funds could be external in nature or due to selecting funds that may not be appropriate for your risk profile.
- You must ensure that you understand and are comfortable with the investment objective and strategy of the products that you invest in.
- Many behavioral biases can also creep in while making investment decisions and it is important to be aware of them.
- Seek the help of a professional financial advisor to make sound investment decisions and select suitable funds.