Mutual funds are widely considered to be one of the best ways to invest in the stock market. This is primarily due to the fact that you can choose to invest in them in monthly installments via a Systematic Investment Plan (SIP).
That said, while mutual funds may have their own share of advantages, they have quite a few disadvantages as well. Here’s a quick look at 8 reasons why this investment option is a risky deal.
The primary reason why mutual funds are considered to be risky deals is due to the fact that the returns they offer are not stable or guaranteed. Since the performance of the fund is linked to the movement of the market, mutual funds only offer returns if the market performs well. If it doesn’t, they may not provide any returns at all and can even lead to capital loss.
Mutual fund investments suffer from market risk, which is the risk of facing losses due to adverse market movements. Some of the examples of market risk that mutual funds suffer from are as follows - economic developments, geopolitical scenarios, government policies and legal framework, investor sentiment, interest-rate movements, and unexpected large-scale events.
Asset risk is the risk of facing losses due to the degradation in the quality of the asset or the company issuing the said asset. Since mutual funds also invest in debt instruments such as corporate bonds and debentures, asset risk is very much a part of it. For instance, a company failing to make payments to its debenture holders on time or the downgrading of the company’s credit ratings are two examples of asset risk.
Liquidity risk is the risk of not being able to sell an investment. Although mutual funds are highly liquid, there are certain categories of funds like ELSS, which have a fixed lock-in period. During this period you will not be allowed to sell your investment.
Such funds are said to possess liquidity risk since you cannot sell the investment and recover your invested amount as and when you need it. Therefore, when choosing mutual funds, it is a good idea to opt for ones that don’t have a lock-in period if you’re planning to withdraw it prematurely.
Inflation risk is the risk of not being able to generate returns that match up to or exceed the effects of inflation. Seeing as the returns from mutual fund investments are linked to the market, there’s a significant possibility that you may not be able to get inflation-beating returns.
Mutual funds are required to adhere to a certain set of rules and regulations. Non-compliance of the prescribed laws and practices may lead to several problems including the dissolution of the fund. Mismanagement of the mutual fund is a major risk that you would have to account for.
If you use your mutual fund investment as a collateral for obtaining a loan, there’s another risk that you should be aware of - loan financing risk. It is the risk of the returns from the fund not matching the loan interest payments. It also includes the risk of having to come up with additional collateral due to a drop in the mutual fund investment value.
Mutual funds are managed by fund houses through a dedicated individual or a team of individuals known as fund managers. The fund manager’s actions directly impact the performance of the mutual fund. Questionable decision making on the part of the fund manager can adversely impact the performance of the fund.
With this, you must now be aware of the risks associated with mutual funds. Now, despite these risks, mutual funds are a great way to create wealth in the long-term. However, choosing mutual funds is only ideal if you’re willing to take on risk. If not, there are plenty of other low-risk investment options available.
Now, if you’re interested in investing in a mutual fund, an upcoming IPO, or the stock of a company, you would need to have an active demat account. If you don’t, then all you have to do is visit Motilal Oswal. You can open a demat account within a few minutes through an entirely online process.
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