Mutual funds allow investors to pool their money with other investors to create a professionally managed investment portfolio. While mutual funds provide diversification and convenience, they are still vulnerable to market risk like all other securities. This blog explores why mutual funds carry market risk, what market risk is and the various factors that make mutual funds susceptible.
Defining Market Risk
Market risk refers to the inherent risks faced by all investments due to the unpredictable and uncontrollable nature of the financial markets. Also known as “systematic risk,” market risk is the possibility that an entire market, economy, or asset class will decline in value, leading to losses in investments.
Market risk cannot be avoided through diversification within the market since it affects the market as a whole. It also cannot be mitigated by the actions of any single company or entity. Market risk impacts all investors and investment products, including mutual funds.
Why Mutual Funds Carry Market Risk
While mutual funds provide instant diversification across many securities, they cannot escape systematic market risk for several reasons:
1. Fluctuating Share Prices
The share price of a mutual fund goes up or down along with the value of its underlying portfolio. So when stock or bond prices decline in value, so does the fund’s net asset value and share price.
2. Vulnerability of Asset Classes
Most mutual funds focus on specific asset classes, like stocks or bonds, that have inherent risks. The performance of a focused fund is vulnerable to market swings affecting that asset class.
3. Passively Managed Funds
Passively managed index funds aim to match market performance rather than outperform. This means they fully ride both uptrends and downtrends in the market.
4. Broad Market Events
Unpredictable sociopolitical or economic events affect the market as a whole, impacting all funds holding affected securities.
While mutual funds themselves don’t necessarily become more or less risky over time, investors face market risk when investing in any fund exposed to the whims of the market.
Types of Market Risk Affecting Mutual Funds
Mutual funds face different types of market risk depending on their portfolio composition:
1. Equity Risk
The possibility of declines in the stock market poses equity risk for mutual funds holding stocks. Since stock fund portfolios only include equities, they are highly sensitive to stock market volatility. But balanced and hybrid funds containing stocks also carry equity risk in proportion to their stock allocation.
2. Interest Rate Risk
Bond prices tend to fall when interest rates rise. This interest rate risk means an increase in rates can reduce the value of bond holdings in a mutual fund and lower its overall returns. This impacts bond funds, income funds and balanced funds with bond exposure.
3. Credit Risk
There is a possibility that a bond issuer could default on interest payments or principal repayment. This credit risk means bonds may not pay out as expected, lowering the value of bond fund shares. Government bonds generally have lower credit risk than corporate bonds.
4. Inflation Risk
As inflation rises over time, it erodes the purchasing power of a currency. This impacts funds heavy in cash-equivalent holdings like money market funds. Returns may not keep pace with inflation.
5. Country Risk
Funds investing globally can face country-specific risks. Events in a particular country can negatively impact stocks or bonds traded there, affecting foreign or global funds with exposure.
6. Sociopolitical Risk
Major sociopolitical events like wars, elections, civil unrest or acts of terrorism can adversely impact markets. Geopolitical uncertainty makes markets more volatile across geographic regions.
Managing Market Risk
While market risk cannot be fully avoided, there are ways mutual fund investors can aim to mitigate it:
1. Asset Allocation
Fund investors should align risk tolerance with an asset allocation strategy fitting their timeline and goals. Conservative allocations have more fixed income to reduce risk.
2. Diversification
Spreading investments across different assets, market caps, industries, and geographic regions helps smooth out market volatility. Diversification allows parts of the portfolio to potentially offset losses in others.
3. Rebalancing
Revisiting portfolio weightings periodically and rebalancing back to target allocations helps control risk. Rebalancing limits overexposure as certain assets drift up or down.
4. Time Horizon
Having a sufficiently long time horizon before needing the money allows riding out near-term volatility. Long-term investors are more likely recoup short-term losses.
5. Cost Averaging
Investing equal amounts regularly over time takes advantage of dollar-cost averaging. More shares are purchased when prices dip lower.
Conclusion
While unable to escape systemic market risk, mutual fund investors can take steps to manage risk relative to their situation. The key is assessing risk tolerance, diversifying strategically, maintaining balanced exposure across assets, staying invested for the long term, and regular portfolio rebalancing.
Frequently Asked Questions
Market risk refers to the inherent risk faced by all investments and securities due to the unpredictable nature of the financial markets. It is also called systematic risk.
Mutual funds face market risk because their share prices fluctuate based on the value of the securities within their portfolios. When stock or bond prices decline, so does the fund's net asset value.
The main types are equity risk, interest rate risk, credit risk, inflation risk, country risk, and sociopolitical risk. Different funds are exposed to different market risks based on their portfolio allocation.
No, market risk cannot be fully avoided. It is inherent in all investments tied to the financial markets. However, proper diversification and asset allocation can help mitigate market risk.
Diversifying across many securities, assets, market caps, industries, and regions means part of the portfolio may hold up when other parts decline due to market swings.
Dollar cost averaging involves investing equal fixed amounts regularly over time. More shares are purchased when prices are low, reducing the impact of volatility.
Align risk tolerance with asset allocation, diversify, rebalance periodically, have a long time horizon, and use dollar cost averaging to mitigate market risk.
Market risk is short term, while investing is long term. Time in the market lets investors ride out temporary declines and benefit from eventual upswings.
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