Do you wish to invest in mutual funds but worried about their safety? Have questions regarding the risks of investing in mutual funds? Worry not, here in this article, we cover all your questions regarding the safety of mutual funds. We also help you decide the right type of mutual fund based on your risk appetite.
Investing Mindset of Indians
For decades, millions of Indian investors have preferred investment products that guarantee the safety of their capital. Hence, they opt for fixed deposits, and recurring deposits and banks and post-offices are considered as the safest places to invest one's hard-earned money. Both FDs and RDs offer guaranteed returns and are not dependent on the fluctuations of the share market.
In spite of their increasing popularity, mutual funds still do not garner the trust of general investors. Also, very often, investors equate mutual funds with other quick-money schemes like chit funds that promise huge returns. However, the reality is that mutual funds are a relatively safe investment option.
It brings us to the pressing question,
Are mutual funds safe?
Mutual funds do not offer the guarantee of returns. Also, you would have read that mutual funds are subject to market risks. Despite these risks, mutual funds are not unsafe. When it comes to the safety of their investment products, most investors are concerned about the following two factors:
Protection of their capital
Prevention from investment frauds
Let’s evaluate mutual funds based on these two factors:
Protection of Capital
It's true that mutual funds do not guarantee any returns and are subject to market risks. However, the risk in mutual funds is minimized in several ways. Firstly, mutual funds are managed by professional fund managers. These fund managers ensure that investors do not face any unnecessary risks.
Secondly, investors benefit from diversification. Mutual funds invest in multiple stocks, bonds and securities, instead of investing in a specific bond or stock. Hence, it reduces risks. Also, as an investor, you can regularly review your portfolio, evaluate the performance and switch investment types as and when needed, to reduce the risk exposure.
Thirdly, there are several types of mutual funds that have varying levels of risks. For instance, debt funds are considered ideal for conservative investors as the associated risks are low. Also, conservative investors can avoid investing in themed funds (specific to a sector), small and mid-cap funds as the volatility is quite high. They can instead opt for hybrid funds that minimize risks.
Probability of Investment Frauds
One of the biggest worries for investors is the chance that the investment company runs away with their hard-earned money. This is the primary reason why most investors opt for FDs and RDs in banks and post-offices, as banks are considered trustworthy. And, not to mention the several instances where chit-funds have gone awry, due to fraudulent investment companies.
However, investors need not worry about fraudulent activities when investing in mutual funds. To protect investor's interest, mutual funds are regulated by AMFI (Association of Mutual Funds in India) and SEBI (Securities and Exchange Board of India). Before a company can offer a mutual fund, it has to apply for and obtain special licenses. Since SEBI directly regulates mutual fund companies, they are as safe as banks.
Another concern regarding mutual funds is that investors are not ready to trust mutual fund distributors. However, you can put aside your worries. Even in the worst-case scenario, if the distributor were to close shop, you can always approach the parent asset management company and redeem the units you own.
Different Types of Risks associated with mutual funds
Mutual funds have different types of risks, like:
|Type of Risk||Type of Investment that is Affected||How can the mutual fund lose money?|
|Market Risk||All investment types||The value of your mutual fund scheme could reduce due to fluctuations in the market.|
|Liquidity Risk||All investment types||Your mutual fund scheme may not be able to sell units as it has declined in value, and there are no buyers|
|Interest Rate Risk||Fixed income securities||The cost of fixed income securities drops when interest rates rise.|
|Currency risk||Investments made in a foreign currency||If the foreign currency loses value, then your investment also loses a subsequent value.|
|Credit Risk||Fixed income securities||If the bond issuer cannot repay it, then the bond’s value becomes worthless.|
|Country Risk||Foreign investments||Foreign investments could decline in value due to instability, political turmoil in the country of investment.|
Classification of Mutual Funds based on their Risk Levels
The AMFI (Association of Mutual Funds in India) has specific guidelines on how to classify a fund based on the associated risk levels. It has devised a risk-o-meter with five levels. The risk-o-meter is colour-coded and is easy to understand. Investors can choose a mutual fund scheme that matches their risk profile.
Here is an explanation of the different levels of the Risk-o-meter
It’s the least risky of all mutual fund schemes. Mutual funds that fall under this category invest in low-risk instruments like government securities and gilt funds. However, just like all mutual funds, it doesn’t offer any guarantee of returns.
Who is it for? It’s ideal for conservative investors looking for safe investment options.
Mutual funds that fall under this category invest in short-term securities and bonds, which have a maturity term of 1 to 3 years. It generates lower-interest rates but comes with lower risks.
Who is it for? Ideal for investors with an investment horizon of 2 to 3 years.
Funds that fall under this category include monthly income plans. While the nomenclature states monthly-income, it doesn’t guarantee returns.
Who is it for? Ideal for semi-conservative investors who want to generate decent returns while keeping their risk exposure limited. Generally, moderate risk plans work well for investors with a medium to the long-term investment horizon.
Moderately High Risk
Mutual funds that have good exposure in equities and related instruments fall under this category. Most moderately high-risk funds are balanced, diversified and equity-oriented.
Who is it for? Suitable for investors who are looking to generate their wealth over a long period.
Funds that fall under this category include thematic funds, sector-specific funds and international funds.
Who is it for? Suitable for investors who want to generate high returns but can afford high risks.
The Final Word: Are Mutual Funds Safe for Investments?
To summarise it succinctly, mutual funds are safe for long-term investors who are looking to build their wealth. If you have an investment horizon of 3 to 5 years or more, mutual funds are an excellent investment option.
As an investor, you should not be too worried about the short-term fluctuations of your mutual funds. By choosing the right mutual fund scheme, that matches your investment goal, investment horizon and risk appetite, you can pick a winning fund that helps in wealth generation.
However, make sure to do your homework — research on the different types of mutual fund schemes available on the market. Evaluate the market performance, the returns generated over the years and select a winning fund that suits your investment profile.