“Mutual fund investments are subject to market risks.” The sentence is so familiar that most people stop hearing it. It is worth taking literally, because it describes something that will happen to every investor at some point: the value of an investment will fall, sometimes sharply, and nobody will have been able to say in advance exactly when.
What market risk means
A mutual fund scheme holds securities whose prices are set in the market every day. The scheme’s NAV moves with those prices. Market risk is the possibility that prices fall and the value of your investment falls with them, for reasons that have nothing to do with the quality of the scheme you chose.
Mutual funds are not deposits. There is no fixed rate and no assurance that you will get back the amount you invested. Returns are not guaranteed.
The main kinds of risk
Different schemes carry different mixes of these.
- Equity price risk. Share prices respond to company results, the economy, interest rates, global events and investor mood. Equity schemes can fall a long way and can take years to recover.
- Interest-rate risk. When interest rates rise, the prices of existing bonds fall. Debt schemes holding longer-dated bonds are more sensitive to this than schemes holding short-dated ones.
- Credit risk. A company or institution that has issued a bond may delay or fail to pay interest or principal, or its credit rating may be cut. Debt schemes holding lower-rated paper carry more of this risk.
- Liquidity risk. In stressed markets, some securities become hard to sell at a fair price. This can affect a scheme’s value and, in rare cases, how quickly it can meet redemptions.
- Concentration risk. A scheme focused on one sector, theme or small set of holdings depends heavily on how that narrow area performs.
- Inflation risk. Money that grows more slowly than prices loses purchasing power, even though the number in the statement goes up. Avoiding all market risk therefore carries a risk of its own for long-term goals.
A scheme’s specific risks are listed in its Scheme Information Document, and its overall level is shown on the riskometer.
Volatility and loss are not the same thing
A fall in NAV is a fall in the current value of your units. It becomes a realised loss only if you redeem at that point. This distinction matters, but it should not be turned into false comfort. If you need the money while values are down, the loss is real. And not every fall reverses: a scheme can stay below your purchase value for a long time, and there is no rule that says it must recover.
This is why the time you have matters so much. The longer you can leave money invested, the more room there is for a decline to be followed by a recovery. It is a matter of likelihood, not a promise.
What an investor can do
You cannot remove market risk. You can decide how much of it to take and prepare for it.
- Match the money to the horizon. Money needed in the near term should not depend on how equity markets behave.
- Hold an emergency fund. It prevents you from being forced to sell long-term investments at a bad time.
- Decide your asset allocation deliberately. The split between equity and debt sets how much your portfolio will swing.
- Diversify. Do not depend on one company, sector, issuer or theme.
- Read the riskometer and the risk factors before investing, and check that the level fits the fall you could live with.
- Decide in advance how you will behave in a decline. Selling in a panic and waiting to return until markets feel comfortable again is one of the most common ways investors turn a temporary fall into a permanent loss.
- Review periodically, not constantly. Checking values every day makes ordinary volatility feel like an emergency.
What nobody can do
Nobody can reliably predict when markets will fall or recover. Be cautious of anyone who claims to, and of any suggestion that a particular scheme or method has removed the risk. Past performance is a record of what happened. It is not an indication of future returns.
The honest summary
Market risk is the price of taking part in markets. It cannot be avoided, only chosen in sensible amounts and lived with patiently. The useful question is not “is this risky?” but “how much could this fall, for how long, and what would that mean for the goal this money is meant for?” If you can answer that before investing, you are far less likely to be surprised afterwards.