What is Mutual Fund’s Risk: 6 Ways to Measure a Mutual Fund’s Risk?

Investing in mutual funds is one of the popular ways to grow your wealth. While mutual funds give great returns, they come with inherent risks. Thus, before investing in any type of mutual fund, it is important to set your financial goals, study the market and weigh the pros & cons of each mutual fund. This will help you make a diverse portfolio as per your financial goals.  

This blog explores the types of risk involved in mutual funds, ways to measure it, factors that affect mutual funds and selecting a mutual fund based on its risk factor. 

What is Mutual Fund Risk?   

The mutual fund includes various types of investment instruments like equity, debt, or corporate bonds. The prices of these fluctuate due to many factors. This makes the mutual funds risky, as the prices keep fluctuating. If you invest more in high-risk mutual funds, you may potentially face a loss.

However, as an investor, you can make smart decisions by understanding different types of mutual funds. Additionally, keeping a diverse portfolio minimizes the impact of the risks involved. 

Also Read: What Is SIP Investment – Meaning and How It Works 

Importance of Understanding Mutual Fund Risk    

Mutual funds are one of the ways to grow your wealth. However, when you invest in mutual funds, it is important to understand the risk. Here’s why: 

• Determine your Financial Goals: Understanding Mutual fund risk helps in assessing your financial goals for the long term and short term. Choose mutual funds based on your financial goals, risk appetite, and investment horizon. 

• Factor in Risks Involved: Each type of mutual fund has a certain level of risk attached. Understand these risks and make investment decisions, accordingly. 

• Maximize Returns: By understanding the risks and rewards of each type of mutual fund, an investor can choose to optimize their funds’ performance. For instance, an investor may put 60% of their money in high-risk equity mutual funds for growth and 40% in low-risk debt funds for stability, ensuring their portfolio balances potential returns with safety. 

• Smart Decision Making: When an investor has a clear understanding of the risks involved, they are more likely to diversify their portfolio to reduce risk. They also have realistic expectations when the market downturns. 

• Portfolio Diversification: Knowledge of risks allows investors to build a diversified portfolio, spreading risk across different assets to reduce potential losses.  

Types of Risks in Mutual Funds  

Mutual funds come with several risk factors. As an investor, it is important to understand these risks before you invest in any mutual funds. Here is a list of risks in mutual funds:    

1. Market Risk: Several external factors like policy changes, recession, natural disasters, and political changes impact market performance. This in turn impacts the return on investment.  

2. Credit Risk: Credit risk refers to cases when the issuer of the scheme fails to pay the agreed-upon interest. Fund managers usually choose high credit-rated securities to lower the risk, but they may sometimes go for low credit-rated (high-risk) securities to earn more returns. While these securities may give higher returns, they increase the chances of not being paid.   

3. Liquidity Risk: Liquidity risk refers to losses incurred from not being able to liquefy the investments. This happens because either the investments are in the lock-in period or there are no buyers for it.   

4. Interest Rate Risk: Changes in interest rates affect debt mutual funds the most. These fluctuations in interest rates affect the returns. 

5. Reinvestment Risk: This refers to the possibility that the investor may not be able to reinvest cash flows at a rate equal to their current return. Reinvestment risk is typically seen in bond investing but any other type of cash flow also exposes the investor to this risk.   

6. Inflation Risk: High inflation affects the returns on investments. For instance, if you earn 9% returns on your investment and the inflation rate is 5%, then the actual net return you earn is 4%. 

Also Read: Types of Mutual Funds: Categories Explained for Every Investor

6 Ways to Measure Mutual Fund’s Risk   

If you want to invest better, it is important to understand how mutual fund risk is measured. This will help you gauge the performance of the mutual fund and make investment decisions based on that factor. Here are 6 ways to measure a mutual fund’s risk and safeguard your investments.  

1. Standard Deviation: The standard deviation measures the deviation of data from its mean. In terms of mutual funds, it represents the volatility of the fund.   

For instance, if a mutual fund has an average return of 10% over 5 years and a standard deviation of 3%, it means the fund’s returns typically range between 7% and 13%, reflecting its volatility. This means that the mutual fund is a high risk mutual fund.  

2. Sharpe Ratio: The Sharpe Ratio measures risk-adjusted performance. The Sharpe Ratio indicates whether a mutual fund’s returns are due to the investment decisions taken by the fund manager, or it was the result of excessive risk.   

3. Beta: Beta measures the relative volatility of the stock. Thus, it does not give the risk of the asset but only the relative risk of the asset.  

4. Alpha: Alpha measures a fund’s performance relative to its benchmark. For example, if the Sensex delivered 12% in the past year and a fund benchmarked against the Sensex delivered 14%, the Alpha is +2%. Conversely, if the fund delivered 10% then the Alpha is -2%.   

5. R-Squared: R-Squared measures funds’ performance as against its benchmark. It ranges from 0 –100, with 100 being the perfect benchmark. 

• High R-squared: The fund performs almost like the benchmark. In actively managed funds, this means the fund manager isn’t doing much differently from the index.  

• Low R-squared: The fund performs very differently from the benchmark. This might mean it uses a unique strategy or offers better variety for your investments.   

6. Value at Risk (VaR): The statistic that quantifies the potential financial losses within a portfolio or a firm. This is calculated based on the recent performances of these securities.  

Factors Affecting Mutual Fund Risk   

Many factors affect mutual fund risk. These conditions (like economic or fund manager’s skill) conditions (like economic or fund manager’s skill) affect this risk. Factors that affect mutual fund risk as stated below: 

• Economic Conditions: Any significant changes in the economy like unemployment rates or inflation can impact the fund’s performance. 

• Interest Rate: Changes made by the central banks regarding the interest rate policies directly affect fixed-income assets in mutual funds. 

• Fund Manager’s Skill: The expertise of the fund manager in selecting assets and making investment decisions impacts the risk level. 

• Diversification: A well-diversified portfolio reduces the impact of risks, while a concentrated portfolio increases risk. 

• Fund Strategy: The risk is impacted by the investment strategy of the fund house (e.g., value, growth, or aggressive investing) 

• Market Conditions: Broader market trends (bull or bear markets) can influence the risk of mutual funds, especially equity funds. 

• Investor Behavior: The behavior of investors (e.g., panic selling during market downturns) can increase the risk. 

• Currency and Geopolitical Factors: International investments are affected by currency fluctuations and geopolitical events.  

Choosing the Right Mutual Fund Based on Risk   

To choose the right mutual fund based on risk, you should consider your financial goals (buying a house or retirement fund). Once you determine your investment goal, you can choose which type of mutual fund to invest in. These mutual funds could be debt mutual funds, equity mutual funds or hybrid mutual funds.  

• Equity Mutual Fund: Equity mutual funds fluctuate due to market conditions. They generate capital appreciation over the long term. These mutual funds are more suited for investors who have a high-risk appetite and long-term investment strategy. 

• Debt Mutual Fund: Debt mutual funds are more stable as compared to equity mutual funds. They are low risk mutual fund. They provide regular income and capital preservation. These include fixed-income securities like corporate debentures, bonds, treasury bills etc. However, the returns could be lower than equity funds. These may be more suitable for investors with a moderate risk appetite and short-term investment strategy. 

Also Read: What is Mutual Fund Return and how to Calculate it?  

Conclusion   

While mutual funds generate good returns, it is imperative to understand the risks involved. You need to have a financial goal and a strategy in place before you invest in any mutual fund. You need to understand different types of mutual funds and how they perform. As an investor, you need to assess your risk appetite and investment horizon to make better investment decisions. Mutual funds are subject to market risk. If you understand market fluctuations and don’t get swayed away by a temporary market downturn, mutual funds are a good investment option to explore.