We all know, Investment in Mutual Funds does not eliminate risk, rather it spreads risk among various securities. The success in the form of better return from mutual funds will depend upon understanding and the tolerance by the investors of the following categories of risk:
- Instrument Risk – This is related to risks and opportunities in the three general group of mutual funds viz. money market, bond and stock. Investor has to find out the availability of any other alternatives to mutual funds that could deliver similar returns at low risk, low cost and with little added effort on his part.
- Market Risk – Investor has to focus on the market forces that affect the inherit risk exposure of different types of funds.
- Portfolio Risk – The investor should look for special characteristics of the make-up of a specific fund – its holdings and the investment techniques used by the manager and define its unique risk profile e.g. beta.
- Business Risk – It deals with the business risk e.g. competitive position that affects the earnings of a company whose shares are a part of fund portfolio.
Risks normally found in various types of funds:
- Risk in Money Market Funds – Since money market mutual funds invest in secured Central Government securities, high-rated commercial papers and corporate debt, the risk of losing interest and capital is minimum when compared to other investment. However, the risk is in the form of fluctuations in interest rate, as yield on money market funds vary with the change in NAV, which changes due to change in the prices of money market instruments due to volatility in interest rate.
- Risk in Bond Funds – Like money market funds, bond funds are also exposed to interest rate risk. Further, the composition of bond portfolio exposes an investor to a risk, which is due to the presence of junk bonds in the portfolio composition. The risk of capital erosion is less as compared to stock funds.
- Risk in Stock Funds – Stock funds are more risky when compared to the money market funds and bond funds. The risk in stock funds is in the nature of the price volatility of stocks in a portfolio. Stock funds consisting of equity prone to high price fluctuation or dealing in speculation, will lead to excessive gains or losses by way of increased or decreased NAV.
Strategy for risk reduction
Investor should try to select funds with fluctuation patterns that tend to offset one another. To illustrate, let us consider a situation where a conservative investor has a portfolio containing two different funds. One fund invests primarily in natural resource-oriented stocks, which normally do well in inflationary periods. The other fund invests primarily in financial stocks – such as Central Government and financial institutions’ securities, which typically do well in disinflationary periods. If a portfolio is constructed consisting of both funds, their fluctuations will, in part, tend to cancel one another as inflation rates vary over time. As a consequence, the risk level of the overall portfolio will be reduced below the risk level of either individual fund. But an investor should remember that every individual fund must also invest in numerous stocks located within many different industries to further limit the business risk. Taking the fullest possible advantage of the portfolio effect requires diversifying in two important was as given below:
- Diversification by Investment Style – As an investor, he/she must strive to diversify his/her holdings across different investment styles and seek to select only the best performers within each particular category. An investment style is simply a set of rules, guidelines, or procedures followed by fund managers when selecting stocks. Some of such stocks include blue chip companies, cyclical stocks, interest sensitive stocks, high-technology stocks, stocks with strong earning growth rates, undervalued companies, companies with strong cash flows, etc.
- Diversification by Investment Objective – The business risk can be further reduced by adopting the second strategy – diversifying across investment objectives. There are different types of funds like industry specific fund (aggressive fund), diversified and balanced fund (moderate fund), bond fund (conservative fund) and money market fund (extremely conservative). Each of these funds of different objectives. An investor should invest a proportion of his/her investible resources among all these funds so that his/her risk is further reduced.