Mutual funds are collective investment schemes that pool investors’ money and invest the assets in a diversified portfolio of stocks, bonds, or other securities. The mutual fund’s investment portfolio is managed by a professional fund manager who hedges against uncertainties and navigates the market to maximize returns.
Mutual funds come in distinct options that cater to each individual investor’s risk appetite, financial objectives, and financial positions. Mutual funds make up a diversified investment product that allows retail investors to gain exposure to different asset classes that may have otherwise been unavailable.
When you invest in a mutual fund, you buy units, and the money is pooled with that of other investors. The collected money is then invested in a mix of assets, which could include stocks, bonds, money market instruments, gold, and real estate, depending on the mutual fund’s investment objective.
The mutual fund’s investment objective is dependent on the asset class or combination of asset classes invested. Mutual funds offer the advantage of benefiting from the expertise of the fund manager, who takes investment decisions for the fund.
Investing in mutual funds comes with an inherent risk as it is impossible to predict the future performance of the mutual fund. As an investor, understanding the risk profile of mutual funds is crucial to help you make informed decisions on the suitable mutual fund investment options available based on your risk appetite. Here is a closer look at understanding the risk profile of mutual funds.
What is Risk Profile?
Risk profile refers to an investor’s willingness and ability to take on financial risks in the investment process. It also considers the purpose for which one is investing and the investor’s financial goals. Understanding your risk profile is critical in selecting mutual fund schemes that align with your financial goals and risk appetite.
What Determines Your Risk Profile?
1. Investment Objectives
When investing, it is essential to have a clear investment objective, which helps determine the amount and type of risk you are willing to take on. Investment objectives vary, ranging from income generation, capital appreciation, wealth preservation, and tax-saving purposes.
2. Financial Position
Your financial position, including your income, expenses, assets, and liabilities, plays a crucial role in determining your risk-taking ability and your overall risk profile.
3. Time Horizon
Your investment horizon – the time for which you are willing to stay invested – also determines your risk profile. An investor with a longer investment horizon is more comfortable taking on greater financial risk since they have more time for potential returns on investments to outperform the market.
4. Risk Tolerance
Risk tolerance is the measure of your comfort level with the market’s difficulties. Risk tolerance will determine your ability to withstand losses and meet your financial goals.
Types of Risk Involved in Mutual Funds
1. Market Risk
Market risk is the most common type of risk associated with investing in equity mutual funds. This risk arises due to fluctuations in the stock markets leading to a fall in the net asset value (NAV) of mutual funds. In a volatile market, mutual fund values might fluctuate, resulting in losses to investors.
2. Credit Risk
Credit risk is the risk that the borrower of a security held in the mutual fund may default on payment. For example, if a company that has borrowed from a mutual fund opts not to redeem the amount owed, it results in a loss for the mutual fund.
3. Interest Rate Risk
Interest Rate risk arises when there are changes in the interest rates, affecting the net asset values of mutual funds. There is a direct relationship between interest rates and mutual fund performance. When interest rates increase, bond prices fall, negatively impacting the value of the mutual funds.
4. Inflation Risk
Inflation risk refers to the decrease in purchasing power due to increasing prices. A high inflation rate reduces the purchasing power of the rupee and, in turn, negatively affects the mutual fund’s returns. Inflation risk is a significant concern for mutual fund investors as it is one of the primary risks associated with investing. Mutual funds may be affected by inflation risk, especially those that invest in fixed-income securities such as bonds and treasury bills. The interest rates these securities yield may not increase at the same pace as inflation does. This may translate to a loss in purchasing power for mutual fund investors, who receive lower returns on their investments over time.
5. Liquidity Risk
Liquidity risk is the risk that mutual fund units may not find sellers easily in the market. Illiquid assets like real estate take a longer time to sell, and the process could affect the mutual fund’s performance if the portfolio contains such assets.
How to Assess Your Risk Profile
Understanding your risk profile can help you choose the best mutual fund scheme that meets your financial goals. Here are some of the things to consider when assessing your risk profile:
1. Investment objectives – You need to have clear financial goals that define your purpose for investing.
2. Financial position – Your investment decisions should align with your financial capability, considering your income, expenses, assets, and liabilities.
3. Risk tolerance – Your tolerance to risk will determine the ability or willingness to lose some or all of your capital investments. A higher risk appetite means that an individual is willing to take on more risk in exchange for potentially higher returns.
4. Time Horizon – The amount of time you are willing to invest should be considered in choosing a suitable mutual fund scheme.
In conclusion, understanding the risk profile of mutual funds is crucial to the investment process. Careful consideration should be taken when assessing an individual’s risk propensity, financial position, time horizon, and investment objectives before selecting a mutual fund. With the Bajaj Finserv App, you can get personalized investment guidance and real-time updates on your mutual fund investments, ensuring you always stay informed on your investments. Download the app today and get investment guidance from our experts to enhance your investment decisions!