Almost every investment entails risks. Real estate, stocks, or gold are subject to risks associated with their respective industries, government policies and overall business sentiment in the economy.
One of the reasons why many investors incur huge losses when they invest is not understanding the risks these products carry. No wonder, seasoned investor Warren Buffet once remarked, ‘Risk comes from not knowing what you're doing’. Thus, it is important that you understand the risks associated with investment products.
In recent years, unfavourable developments associated with mutual fund schemes have taught lessons in risks to many investors. After a reputed asset management company had to wind up six debt schemes, savvy investors have started paying special attention to risks while investing in mutual funds. The capital market regulator—Securities & Exchange Board of India (SEBI)—has also taken steps like a revision in the risk-o-meter and the introduction of a potential risk class matrix for debt funds.
In this context, it is important to understand exactly two things before investing:
- What are the risks associated with equity and debt funds?
- How do these risks differ from each other?
What is an Equity fund?
An equity mutual fund scheme aims to generate long-term capital appreciation by investing in stocks and equity-related instruments such as options and futures. These schemes are a suitable investment choice for investors who want to create a large corpus by investing over a long period of time.
Risks associated with equity funds
- Systemic Risk
Since equity funds primarily invest in shares, volatility in share prices cannot be avoided. The value of a portfolio keeps changing almost every minute during the trading hours of the stock market. This exposes investors in equity funds to market risks. If the broad market crashes due to an external factor such as war or a fall in government, then stock prices will also tank. In such a scenario, there is not much an investor can do but wait for the situation to improve. This risk is technically known as systemic risk.
- Sector or industry-specific risk
Some equity funds are more impacted by sector or industry specific risks. These include equity schemes with concentrated portfolios where investments are concentrated in a smaller number of stocks with high allocations to these stocks. Sectoral funds that only invest in companies from a specific sector (eg. Banking, Real Estate), and thematic funds where the investments are focused on a particular opportunity are also exposed to sectoral risks. For investors in such funds, the secondary market could serve as an efficient barometer that reflects the changing fundamentals of a sector and the stocks in it.
- Currency Risk
Investors sometimes invest in an equity fund which invests in stocks listed overseas. Also, investors could also invest in stocks of companies that earn their revenues from various geographies involving multiple currencies. Companies that a fund invests in may be importing a key raw material. All these situations entail significant currency risk. Sales and expenses can vary materially due to the changes in exchange rates, and that in turn, could impact the earnings of a company.
- Regulatory Risk
Changes in regulation can impact the growth prospects and profitability of a business. Though the secondary market is fairly liquid for large cap stocks, small and micro-cap companies are not very liquid. This is especially true in times of bear markets when small and micro-cap companies exhibit low trading volumes. This could result in liquidity risk for an equity fund.
What is a Debt fund?
Debt funds work best for investors who want to earn a steady interest income or have a more conservative approach to investing. Debt funds invest in bonds, debentures, government securities and money market instruments among other fixed income options.
Risks faced by debt fund schemes
- Credit Risk
Credit risk is a risk of default - a possibility that the interest due on a bond may not be paid on time or the principal lent is not repaid on time. Higher the chances of a default, higher the credit risk. High interest rate paying bonds generally carry high credit risks as compared to government securities where the interest payable might be lower, but the credit risk is also minimal.
- Interest rate risk
Interest rate risk arises due to changes in interest rates. When interest rates go up, prices of bonds fall; and so does the net asset value of the mutual fund. When interest rates go down, prices of bonds rise; and so does the net asset value of debt mutual funds.
Interest rate risk is more prominent in case of long-tenure bonds as compared to bonds maturing in the near future.
- Liquidity Risk
Debt funds also face a liquidity risk as the secondary market for bonds is not liquid. This is especially true for bonds which are rated AA and below, as many investors find it difficult to sell these bonds near their fair value. Debt funds’ investors, especially credit risk funds, have to be cognizant of this while building their portfolios.
- Inflation Risk
While concentration risk is generally low in debt funds which run diversified portfolios, they are exposed to regulatory risks. However, what is unique to debt funds is inflation risk. If the rate of inflation is higher than the expected return (measured by the yield to maturity) of a portfolio of a debt scheme, then the real rate of return (yield to maturity minus the rate of inflation) turns negative, which makes it unattractive to invest in debt funds. A positive real rate of return helps fixed income investors.
In conclusion, debt funds and equity funds both entail risks. However, the following tried and tested investment methods could help mitigate them.
- Invest in debt funds to finance a short-term goal. Invest in an equity fund for higher returns over the long term.
- Invest using an SIP and benefit from the power of compounding and the risks being distributed over the long term.
- Diversify investments to mitigate risk of concentration and volatility.
Thus, while any investment will entail a certain amount of risk, understanding these risks and making an informed decision will help you grow your wealth.