Mutual funds Sahi hai! Does the statement hold true in reality as well? We, as a retail investor, mostly see the growth prospects, along with returns and risk. But in the process, we fail to understand that even a particular investment that is categorised as a low-risk investment is bound to have some drawbacks. As an investor, it is crucial you understand these risk factors and drawbacks before you put your money into them and not simply fall into the dilemma of 'super safe investments'.
And the same applies when it comes to Mutual Funds as well. So let's quickly understand what your investment in a mutual fund might fetch you.
How does a mutual fund work?
Before you understand what risks are associated with various mutual funds, it is important you comprehend the mechanism behind the same.
In mutual funds, you will be paying your fund manager, who will, in turn, put your money in various shares and stocks on your behalf. As a mark of you offering the capital, you will be given units of the fund. The fund manager will be collecting the money from several other investors like you and will be investing in different instruments. The fund manager is usually an experienced individual who will be making all the key decisions on your behalf.
Risk of investing in a Mutual Fund
Everything sounds all golden and merry, so where does the problem arise? Mutual funds, just like any other security, will have a certain risk, and some of them are:
- Volatility risk – as we know, mutual funds invest the amount into various listed shares. These shares are subject to price volatility and might either increase or decrease as per market situations.
- Liquidity risk – there is a lack of liquidity which is associated with certain types of investments. For instance, take the case of ELSS. It has a lock-in period wherein the money which is parked cannot be withdrawn or put to another use.
- Inflation risk – there is a high chance that the returns, after deducting the inflation, might not be sufficient to meet the needs or objectives.
- Concentration risk – certain mutual funds are concentrated on a particular industry. In such a case, they carry along with various risks. In such a case, any impact to that specific industry would put you in unstable ground. Further, putting all your funds into one particular fund or investment can also cause a lot of trouble.
NAV and AUM
NAV or net asset value can be termed as the market value of a share in which the mutual fund has invested. It is obtained by calculating the total assets and then deducting the liabilities.
This is a crucial factor as far as Mutual Funds are concerned. It tells us whether the particular investment is good or not. It also notifies us whether we should stay invested or withdraw our investments. It also informs us how the assets in the Mutual fund has performed over a period of time. Hence, the investor must consider this, along with other parameters, before investing.
AUM, on the other hand, is the Asset under management. It gives an account of the fund size or the entire capital that a fund holds and manages. This offers us an idea as to how successful a fund is. However, a fall in that is not something to panic about or worry about. For instance, during the Covid-19, there was a lot of panic in the market, and the investors tried to withdraw all their money, causing the AUM to fall significantly. This is not the inefficiency of the fund manager but simply the high pessimism in the market. A newbie might panic and inherit the herd behaviour without properly understanding the situation. So, think wise.
What should you do?
Having understood the risk associated with Mutual funds, following the pointers mentioned below will help you in navigating the risks associated with mutual funds immensely.
Be fearful when the market is optimistic and vice versa
Say there is a huge rumour that the branded cars are having a faulty engine. The car sale will fall, and as a result, the price will also fall. This would be a suitable time for you to buy a car. Similarly, when the markets are fearful, and there is a lot of panic in the market, a lot of investors will try to get out of the market. They will sell their investments and will intend to hold the cash in hand rather than exploring new investment opportunities.
That is the right time for you to invest. When there is a lot of pessimism in the market, the premium shares will be available at discount. So investing in them will very easily fetch 2 to 3 times more return. You will be offered a lot of opportunities if you look beyond the price fall.
Say there is a new virus that is spreading fast. In such a case, as an investor, it is vital to stay relaxed and have a calm head. The share markets might witness heavy volatility as an investor would fear and panic. At times like this, ensure you do only those things that would help your portfolio grow and don't panic-sell.
Consider each and every factor connected to the fund crucially and analyse them. Invest your money after you are comfortable with dealing with the risks associated with them. There isn't a single mutual fund that is free from all risks. It all depends upon your risk appetite. How much of additional risk you're willing to take to get additional returns is what you need to think properly.
Invest only once you're well-informed about the asset class and convinced that it fits in well into your risk profile and investment objectives.