Does Mutual fund provide risk diversification?
Risk diversification is to reduce the risk
For an investor who has just been introduced to capital markets, it is easy to get carried away.
Someone said, “Life is all about taking risks. If you never take a risk, you will never achieve your dreams, and when it comes to investments, risks are unavoidable.” No investment is immune to market-related threats and has not behaved differently at any point in time. An asset class that offers excellent returns always comes with a high risk. In the same way, for an investment that carries little or no risk, the gains from it are definitely going to be low.
What is risk diversification?
The time you set out to achieve your long-term goals through investing, you knew that risks are a constant factor. Once you assess your risk tolerance ability, the only way to enhance the value of your investment is risk diversification. Risk diversification is to reduce the risk while investing in different asset classes in different market conditions. If you are investing wisely, though, it cannot eliminate the risk but helps to gather the competency to manage it.
How do mutual funds help in risk diversification?
Mutual funds are an investment vehicle that allows you to get exposure to various asset classes like equity, debt, and also real estate & gold. If you carefully choose your mutual funds, these can be the right asset allocation tools that will help you balance your risks and maximise your returns. Mutual funds provide adequate diversification to spread your investment risks across different types of assets while keeping the portfolio safe.
Fortunately, investing in mutual funds makes the job of risk diversification much easier for investors so that a failure of a scheme or an economic slump affecting any one of them will not be disastrous for them. A mutual fund is the best option to obtain instant access to a diversified portfolio investing just in one fund.
Type of Risks
In the financial market, an investor is exposed to various kinds of risks and how mutual funds can help in managing them discussed hereunder.
Risk of Market Volatility
Market volatility is an inherent part of any investment, be it equities, debt, or any other asset class. The macroeconomic or political conditions may impact markets anytime, making them volatile. You cannot expect while investing that there will be no volatility. To protect yourself against it, you can go with the systematic investment plans or SIPs of mutual funds. SIPs allow you to put in small amounts of money at periodic intervals (weekly/monthly/quarterly).
The systematic investment plans (SIPs) help to average out the impact of volatility. Through this, you can be assured of being least affected by market fluctuations. Moreover, you can easily create wealth with the habit of regular investing in SIPs over the long-term.
Risk of Concentration
For an investor who has just been introduced to capital markets, it is easy to get carried away. The temptation to make quick profits individually when a particular stock/sector or asset class is performing well becomes hard to ignore. However, when you overexpose yourself to a specific asset class, you are putting all your eggs in one basket, thereby increasing your risk. If that particular sector or the asset class started performing poorly, you would find yourself amid a loss.
Diversification is an intrinsic part of mutual funds that invest in carefully chosen securities of varied sectors. An aggressive investor who prefers investment in sectoral or thematic funds, the stocks picked by the funds are diversified even within the same industry. As your risks will be well-diversified by investing in mutual funds, the impact of the down market on your portfolio will be limited.
Risk of Taxation
Taxation is a vital part of every investment. If tax savings are your primary concern unless you pick tax-efficient investment products, your portfolio will not be able to attain its maximum potential.
The Equity Linked Savings Schemes (ELSS) of mutual funds are a great option to receive tax benefits on the investment amount. Here long term capital gains return up to Rs. 1 lakh are tax-free in a Financial Year (above Rs. 1 lakh long term capital gain is taxed at 10%).
When you are not willing to lock your money for three years, you can choose diversified equity funds where you need not pay capital gains tax if you remain invested for over a year (long term capital gain is taxed @ 10% for gains more than 1 lakh rupees in a Financial Year). Dividend distribution tax is also applicable for Dividend schemes.
Risk of Inflation
There is another risk you simply cannot avoid as an investor, and that is inflation risk. We know that the Public Provident Fund (PPF) is a tax-efficient option over investments like bank fixed deposits and post office deposits, which are taxable. However, it is essential to know whether it still holds an inflationary risk.
Mutual funds tackle these risks very well. Thanks to indexation benefits for which debt funds too can be profitable in the long-term. Besides, debt funds can be beneficial in falling inflation also. As the relation between bond prices and interest is opposite when interest rates are falling, bond prices will rise.
However, over and above, you receive the benefits of compounding as your investments are locked in for three years.
Investments and risks will always go hand in hand. Therefore risk management is considered an integral part of wealth creation over the long-term. If you can use mutual funds well, you can adequately protect yourself by minimising your losses and maximizing your profits. However, most of us are not competent enough to apply the theories of portfolio structuring to minimise risks, and hence it would be better to consult a professional.
That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.