Why Are Mutual Funds Subject To Market Risks?

“Mutual fund investments are subject to market risks” is a common saying. You will find it at the end of all mutual fund advertisements. It means that the value of your mutual fund investments can go up or down based on market conditions, and there’s no guarantee of positive returns. But the question is, why are mutual funds subject to market risks?

Reasons behind market risks

To understand the reason behind the associated market risks with mutual fund investing, you must understand the underlying structure of mutual funds. Mutual funds pool money from different investors and invest in various securities, such as stocks and bonds. Now, these securities are affected by different market and economic risks, which, in turn, affect funds and exposes them to market risks. Let's explore the connection in detail.

• Fluctuation in stock prices Mutual funds often allocate a portion of their portfolios to stocks whose price is influenced by factors such as company performance, market sentiment, economic conditions and global events. Consequently, a mutual fund's equity holdings can experience significant variations.

• Factors affecting bonds Along with stocks, bonds are another common component of mutual fund portfolios. Bonds are subject to credit risks and interest rate risks. When interest rates go up during periods of high inflation, the value of existing bonds tends to decline. Funds holding a substantial amount of bonds may witness a decline in the value of their bond holdings.

• Economic risks The economy's health plays a crucial role in the performance of mutual funds. Recession, unexpected geopolitical events and economic downturns may negatively impact certain businesses in which a fund has invested. This exposes them to market risks, leading to diminished returns.

• Currency risks Some mutual funds may invest in international securities, exposing them to currency risk. Any change in exchange rates can impact returns when computed in the base currency.

Dealing with market risks when you invest in mutual funds

While you can’t avoid market risks altogether, there are certain ways through which you can deal with them. Some of them are:

• Portfolio diversification Effectively diversifying your portfolio ensures you invest in different asset classes like debt, equity, gold, etc. It helps you balance the portfolio's risk-reward ratio and manage market risks effectively. Diversify your portfolio as per your investment objectives and risk profiles.

• SIP investment Investing through systematic investment plans or SIPs can help you mitigate market volatility in mutual funds. Committing a small but regular monthly amount allows you to ride the market's ups and downs effectively. SIPs facilitate rupee cost averaging, whereby you accumulate more units when markets are down and lesser when they are up. It averages your purchase with time.

Conclusion

Being market-linked products, mutual funds are inherently risky and volatile. As an investor, you must embrace market risks and not avoid them. Through portfolio diversification and SIP investment, you can mitigate these risks effectively.