Risk & reward while investing

The 7 Kinds of Risks that you should know before investing in Mutual Funds

Would you consider Driving to be risky?

It can be risky for someone who doesn’t know how to drive or for someone who is unaware of the basic rules of driving. But for someone who knows the rules and drives well, it must seem like a joy ride. The only risks a good driver can encounter are the risks that are out of his control. For instance, bad weather, rash drivers on the road, break failure, etc. Similarly, when it comes to Mutual Funds, despite doing everything right, there are certain aspects an investor will have to keep an eye out for. Risk assessment, Diversification, Determination of objectives etc, are the few characteristics that the investor can control. But just like everything else in life, there are certain unforeseen events that even your Mutual Fund Manager cannot predict. Thus, despite it being one of the most secure investment options, there are certain things that an investor must look into before investing in Mutual Funds. This is not to say that every investment will face problems until its period of maturity, but that the investors should be aware of the possible issues that they might have to encounter while they are invested in the market.

Market Risk

Type of Investment affected: All

There is a certain type of risk called Systematic risk that is inherent to the entire market or an entire market segment.  This risk affects the market as a whole and is not sector-specific. Another characteristic of this risk is that it is unforeseen in nature. It is unpredictable and unavoidable. This risk cannot be mitigated by diversification.  Unsystematic risk is a type of risk that is sector-specific and does not affect the entire market. Such risks can be abated through diversification.

Liquidity Risk

Type of Investment affected: All

Thinly traded securities carry the danger of not being easily saleable at or near their real value. This is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It is typically reflected in large price movements especially to the downside. The rule of thumb is that, the smaller the size of the security or its issuer, the larger its liquidity risk. The fund cannot sell an investment that is declining in value, because there no buyers.

Credit Risk

Type of Investment affected: Fixed income securities

If a bond issuer cannot repay a bond, it may end up being a worthless investment. In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will pay the interest that it has promised, or repay your principal when the investment matures? If there is even a hint of doubt when you answer any of these questions, you have a lot to think about.

Interest Rate Risk

Type of Investment affected: Fixed income securities

The value of fixed income securities generally falls when interest rates rise. Changing interest rates affect both equities and bonds in many ways. Generally, when interest rates rise, prices of the securities fall and when interest rates fall, prices of the securities rise. Interest rate movements in the Indian debt markets can be volatile leading to the possibility of large price movements up or down in debt and money market securities and thereby to possibly large movements in the NAV (Net Asset Value).

Country Risk

Type of Investment affected: Foreign investments

The value of investments made in other countries depends on the balance of economy and status of the country. Should the political structure change or the conditions in that country become unstable, the value of investments will change accordingly. A simple change in government policies can also have an adverse impact on your investments. Thus, it is important to keep track of the changes in the country in which you have made your investments.

Currency Risk

Type of Investment affected: Investments denominated in a currency other than the Indian Rupee

If you have investments that are denominated in a currency other than the Indian Rupee, the slightest difference in the other currency will have an impact on your investment. If the other currency increases in value against the INR, it is advantageous for you, but if the other currency declines against the INR, the investment will lose value.

Inflation Risk

Type of Investment affected: All

Also referred to as ‘loss of purchasing power’, Inflation risk affects all types of investment. There is uncertainty over the future real value of your investment. For example, a loaf of bread that used to amount to Rs. 20 a few years ago, amounts to Rs.30 today. This means that the purchasing power of Rupee has come down. One cannot get the same number of things in Rs.100 today as a few years back. Whenever the rate of inflation exceeds the earnings on your investment, you run the risk that you will actually be able to buy less, not more. Therefore, there is always the risk that Inflation can undermine the performance of your investment.

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