Mutual funds are the safest investment option when compared to other market-linked instruments such as equity stocks. However, they also carry different types of risk, as their disclaimer says: “Mutual fund investments are subject to market risks, read all scheme-related documents carefully.”
This article covers:
- Is Mutual Fund Safe for Long Term?
- Is it Safe to Invest in Mutual Funds During Recession?
- Should I Invest in Mutual Funds When Market is Down?
- Risks of Investing in Mutual Funds
- Is Mutual Fund Safe- Quick Summary
- Is Mutual Fund Safe- FAQ
Is Mutual Fund Safe for Long Term?
Mutual funds are safe for the long term because of the compounding benefits they provide. Each type of mutual fund is ideal to invest in for a certain period, subject to its characteristics, the securities in which it invests, and other market factors.
If you choose to invest your interest earnings in mutual funds, then you will certainly get compounding benefits in the long run and build a good corpus. The long-term meaning is not stagnant in mutual funds like it is in accounting, which is more than one year. In a growing market, the one-year period might be good, but not every time.
Long-term investments are better for equity funds than debt funds. In mutual funds, the general long-term period for equity and hybrid funds is more than three years. Over the years, they can provide inflation-beating returns as compared to traditional investment schemes such as FDs, bank deposits, etc. However, the returns are not fixed in the long term as well.
Factors to keep in mind while investing for the long term:
- Do the research: You should be ready with the research of the mutual funds’ past performance, fund manager experience, securities in which they invest, NAV history, etc. before selecting any type of mutual fund.
- Start with diversification: Diversification is the best way to make decisions for long-term investing. As the diversification quote says “Don’t put all your eggs in one basket.” This suits best for mutual fund planning as well. Invest some money in mutual funds and complement them with fixed-return instruments.
- Do the continuous market analysis: Invest and forget is not suitable for mutual funds because their growth and value change every day based on the securities in which they invest. Therefore, you should keep an eye on your investment and withdraw the money if you are not seeing good returns in the future.
- Know your investment goals: Deciding and analyzing which funds are good is necessary, but along with that, knowing your investment goals, such as your risk appetite and return expectations, is also important. It will help you decide which funds are best for you.
Is it Safe to Invest in Mutual Funds During Recession?
Yes, it is safe to invest in mutual funds during a recession because they help avoid market volatility in the long term. Through a SIP (Systematic Investment Plan), you can get the benefits of purchasing the units at predetermined fixed installments and at a lower price, which in turn provides you with a higher number of units. In this way, you can sell your units later at a higher price, when the market recovers.
With SIP, you can redeem your investment at any time and change or pause the installments as well. It is the best way if you remain patient for the invested period and do not jump from one investment to another seeking better returns in the future.
For low-risk takers, hybrid funds are more suitable in a recession because of the balance they provide between high returns on equity and low risk on debt securities. Equity funds can be a good choice for risk lovers and those who want to keep investing for more than five years.
Investing in debt funds and gold funds is a good choice for investors who are looking to invest in something similar to fixed-income securities. They are certainly the best choice when the market is facing a high drop and you want to secure your invested amount.
Therefore, you can choose to diversify your investment during this period by investing in different types of mutual funds if you want to get the most out of your investment and want to reduce the risk.
Should I Invest in Mutual Funds When Market is Down?
You should invest in mutual funds when the market is down because while investing in mutual funds through the SIP, you should not think about the market conditions if your investment goals match a certain type of mutual fund.
With SIP, you will get the benefit of rupee cost averaging by investing in mutual funds with regular installments. Suppose you have a SIP of ₹1,000 in a mutual fund and today it has a NAV per unit of ₹50, then you will get 20 units. If next month the NAV falls to ₹45, then you will get 22.22 units, and so on. Therefore, the average cost of purchasing the 42.22 units of a mutual fund will be ₹47.37. Over the longer period, this market bearishness will provide more and more units at a lower cost.
Though the SIP provides you with a higher number of units, lump sum investing does not get you into a tough spot if you are patient enough. Once you have invested a lump sum, say in an equity mutual fund, you should remain invested for at least five years, thereby obtaining the best compounding returns.
Factors to keep in mind while investing in a market downturn:
- Reallocate your holdings: This is the first and foremost step when the market is going down because you need to analyze the market’s direction and how much you are at risk from this downturn. You will have to reduce your holdings in the equity funds and buy more of the index funds, which helps reduce the risk of a much greater loss.
- Identify the sectors which are falling: You need to identify in which funds you have invested and what their sector concentration is. For example, in 2022, the IT sector in the US faces a jolt and its stocks also sharply fall. If you have these stocks in your portfolio, then sell these mutual funds.
- Use the book loss to save on tax: Suppose you are holding an equity fund whose NAV is falling. If you already have the STCG (short-term capital gains), then you can still book a loss and repurchase it after some time. In that way, you will not be at a loss, and the book loss helps reduce taxes.
- Never do the guesswork: Guessing where the market is going will not help you make the prediction correctly. You will not know at what point the market will bottom out in the future. The best is to know what your risk appetite is and how you are going to deal with it with the amount you have.
- Ready with the amount to invest: The market downturn will certainly help you buy good mid-cap and large-cap funds at a lower price than their actual value. Therefore, you should be ready with the amount that you want to invest in hand. You should get the most out of it by purchasing the funds at a lower price and selling them later when the market rises.
Risks of Investing in Mutual Funds
General Risk:
- No guaranteed returns
- Investment risk
- Change in NAV
- Fund manager risk
- Concentration risk
- Currency risk
- No guaranteed returns: There is no guarantee that returns will be generated by any scheme or distributed to unit holders. The past success of any scheme does not mean that it will be repeated in the future.
- Investment risk: There are multiple investment risks, such as settlement risk, default risk, trading volume issues, liquidity risk, and loss of invested amount, etc. on the mutual funds.
- Change in NAV: The net asset value, or NAV, of the mutual funds keeps on changing because they rely on the prices of the securities in which they invest. The NAV does not only change with the fluctuations in the equity market but also changes with the economy, interest rates, exchange rates, government policies, taxation in the country, political effects, and other volatility in the market.
- Fund manager risk: The fund manager’s performance is one of the key factors determining the success of any scheme. They are the ones who should be dealing with all types of risk with the selection of stocks, diversifying the portfolio, reacting to all situations, etc.
- Concentration risk: This risk arises when the investor chooses to invest in a single fund or when the fund has concentrated its portfolio in a single sector with one market capitalization, thereby leading to loss and profit based on that only.
- Currency risk: This is the risk that affects the performance of a scheme due to exchange rate fluctuations. The currency risk impacts the US funds and gold funds, and if the Indian currency appreciates once the investment is done, then the returns will get lower.
Risk in Equity Funds:
- Risk of the invested amount
- Market risk
- Liquidity risk
- High competition
- Risk of the invested amount
While investing in equity mutual funds, there is a high risk of losing the invested amount because these funds invest in equity stocks that are highly volatile and more affected by company internal events or any sector-specific events.
- Market risk
These funds carry a high level of market risk because of the listed securities in which they invest. These securities keep changing with the changes in macroeconomic factors such as government policies, SEBI and RBI rules, inflation level, etc.
- Liquidity risk
Liquidity risk comes when the fund manager is unable to sell the securities held in the portfolio because of restrictions on trading volumes and delays in the settlement period. If the value of the underlying securities keeps on declining and the fund manager is not able to sell them, then the scheme may face a subsequent negative impact on its NAV.
- High competition
The competition is very high in equity funds, with more than 300 schemes in the market and only 200 good stocks to invest in. Therefore, the fund manager faces tough competition while investing, and it is difficult to differentiate their scheme from another that investors can choose from. It results in losing money by investing in the wrong scheme.
Risk in Debt Funds:
- Interest rate risk
- Credit risk
- Spread risk
- Liquidity risk
- Counterparty risk
- Prepayment risk
- Reinvestment risk
- Interest rate risk
The debt funds’ interest rate risk starts from the fixed-income securities’ reaction to the economy’s interest rate. If the market interest rate rises, then the prices of these securities will fall, and therefore the debt funds price will also fall. This will affect investors if the maturity period is long.
- Credit risk
Credit risk means the risk of default on interest and principal payments by the issuer of the fixed-income instruments. If the issuers default, then the debt fund will not be able to provide the returns to their unit holders, and the NAV will fall. Also, the prices of the instruments may change with the credit ratings, thereby affecting the NAV of the fund. In general, corporate bonds carry a higher level of credit risk than government bonds.
- Spread risk
Corporate bonds or securities carry high levels of spread risk, which means that there is a difference in earnings between the two bonds having the same tenure but with different credit ratings. The value of the debt funds will fall if the credit spreads of the underlying securities rise.
- Liquidity risk
Liquidity risk in debt funds means how easily a fund manager can sell the securities at their true value or near their valuation (yield-to-maturity). The trading volume restrictions, delays in settlement periods, and transfer issues will restrict the liquidity of the securities which in turn affects their earnings capabilities.
- Counterparty risk
The counterparty risk arises when the party to the transaction does not issue the securities when the payment is done or does not pay the money in securities delivered by the fund manager.
- Prepayment risk
This risk arises when the borrower of the securities pays the principal amount earlier than the due date on which they have issued their bonds. This leads to the loss of debt funds’ interest earnings and also changes the duration of the scheme. The prepayment risk rises when the market interest rate declines and the borrower can pay off the debt easily.
- Reinvestment risk
The reinvestment risk is the risk that reinvested amounts will lead to lower interest rate earnings than the original ones. This will lead to a loss with the increased duration and the lower earnings of the debt funds.
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Is Mutual Fund Safe- Quick Summary
- Mutual funds are safe for the long term because they provide compounding benefits in the long run, and you will get returns on the earnings as well.
- The long-term duration in mutual funds is not the same every time for every fund, and equity mutual funds are more suitable to invest in for more than three years.
- It is safe to invest in mutual funds during a recession because it helps deal with market volatility through the SIP.
- You should invest in mutual funds when the market is down, with a SIP to get the benefit of rupee cost averaging, and with a lump sum for a long time to get the compounding benefits.
- The risks of investing in mutual funds are principal and return amount loss, NAV fluctuations, fund manager risk, concentration risk, currency risk, etc.
Is Mutual Fund Safe- Frequently Asked Questions
1. What are the Main Risks of Mutual Funds?
The main risks of mutual funds are:
- Market risk
- Inflation risk
- Concentration risk
- Credit risk
- Interest rate risk
2. What is the Safest Type of Mutual Fund?
The safest type of mutual fund is a debt fund, which invests in fixed-income securities such as government bonds, TBs, CDs, etc. But they are not completely risk-free.
3. Are Mutual Funds Safer than FD?
No, mutual funds are not safer than FDs because they provide market-linked returns, whereas FDs provide guaranteed returns backed by banks and post offices.
4. Is Mutual Fund 100% safe?
No, mutual funds are not 100% safe because their returns are subjected to the securities in which they invest, which carry a certain level of market risk, inflation risk, interest rate risk, and much more.
5. Is it good to invest in Mutual Funds?
Yes, it is good to invest in mutual funds because they are diversified instruments that are professionally managed and regulated by the SEBI.
