Risk Management in Mutual Funds

Priya looked over at Ravi as they reviewed their mutual fund portfolio. "Ravi, I keep hearing about managing risks in mutual funds. It sounds like a big deal. Should we be worried?" Ravi smiled, "Not at all, Priya. Risk is a natural part of investing, but mutual funds have smart ways to handle it. Let’s explore how they manage risks so we can invest confidently."

With that, they dived into risk management strategies, ready to learn how mutual funds keep their investments steady even in turbulent times.

First, many forms of risk can be taken. One of the most common types is market risk. This refers to the possibility of a decline in the overall market, which may affect your return. A diversified fund has less risk from a market decline due to spreading this risk across various assets. Even a diversified fund will lose value if the market goes down enough.

One way funds may reduce risk is through diversification. This involves investing in a variety of asset classes. For example, instead of investing all the money in one investment, a fund would invest in stocks, bonds, and other securities. That will minimise the risk of having a single lousy investment that affects the entire fund.

Another way to look at this is risk management by adjusting asset allocation. The term "allocation" refers to a combination of various investment types a fund holds. Other funds may have higher equity positions, which are riskier but offer better yields and returns.

Some may be more drawn to cash or bonds, typically less volatile and lower-returning investments. In contrast, others may have a larger proportion of stocks, which usually carry greater risk and return. This mix changes as the fund manager adjusts according to the market condition, the fund's investment objective, and its investors' risk tolerance.

Fund managers, too, carry a huge responsibility in risk management: A good fund manager bases his decisions on a mix of market trends, economic data, and the fund's specific goals. Sometimes, hedging is done, wherein the loss the investment portfolio might sustain is hedged against potential losses from other investments by applying various financial instruments such as options or futures.

Some mutual funds also use stop-loss orders to limit risk. A stop-loss is an order to sell an investment if its price falls below a certain point. This can be a means of automatically cutting potential losses without continual market monitoring. While a stop-loss order can help minimise losses, it may limit the fund's upside if the market bounces back quickly after a decline.

There is volatility, which means how much the value of an investment goes up and down. Stock-based funds are more volatile than those that invest in bonds or cash. But for higher volatility, you get a chance for higher returns. Being young, you may like a more volatile fund for higher returns, though its value may fluctuate yearly.

It is also good to consider the fund's historical performance. Again, while past performance does not guarantee future results, it gives you an idea of how the fund has handled risk in the past. If a fund has performed well during market downturns, it might be better able to handle risks in the future. But remember that even the most prosperous funds cannot predict the future.

The last but not least concern is liquidity risk or the ease and speed with which an investment can be bought and sold. Most mutual funds are pretty liquid, offering the ability to buy and sell shares at the end of each trading day. Some funds invest in more challenging assets to unload in a hurry, so if you need quick access to cash, that could be a problem.

Conclusion:

As they wrapped up their discussion, Priya said, "I feel much better knowing how mutual funds manage risks. Diversification and professional fund management make a difference." Ravi nodded, "Exactly. When you understand these strategies, it’s easier to stay calm during market ups and downs."

In the next chapter, we will analyse mutual fund performance, an essential step in ensuring that your investments are on track and aligned with your financial goals.