First up, it is commendable that you are planning to invest in mutual funds, despite being aware of the fact that risks exist. Most novice investors hear the word risk and flee towards the low-returns generating fixed deposits.

Now coming to the point of risks. Well, one must be aware that risk is inherent to every form of investment. In mutual fund universe, the risk would be of the market not doing well, the fund’s manager not reporting consistent performance, etc.

There are various externalities that impact a fund’s performance and all these factors bring it their quota of risk.

Major risks that mutual funds face:

Market risk: I am sure by now everyone would have heard as well as memorised the saying: “Mutual fund investments are subject to market risks.”

The risk of the market falling is a big risk for everyone who has invested in the market. The market, in itself, rises or falls due to various outside influences and when this happens, stocks react accordingly. As your mutual fund is made up of a collection of stocks, your fund’s performance also depends on the market’s performance. When the market falls, it drags along with it stocks of reputed, blue-cap companies as well as the fledgling ones.

Inflation risk: Inflation in simple terms is rising cost. Thus, when inflation increases, especially when it isnot backed by increase in your earnings, you face the risk of not being able to buy enough mutual fund units, or invest as much as you would in normal circumstances.

Credit risk: This is basically how much you can rely on the company you lend your money to when you invested. The risk here is what if the company decides not to pay the interest, or worse the principal amount, you were promised while investing.

Interest rate risk: Investments are decisions taken at the mercy of interest rates. Thus, change in interest rates of various asset classes affect individual stocks as well as mutual funds.

There exists an indirect correlation between interest rates and prices of securities, and hence mutual funds.

The simplest example would be if the central bank- Reserve Bank of India- hikes interest rates on fixed deposits, then investors will shift their money from equity markets and mutual funds to fixed deposits, thus reducing the prices of the latter.

Investment risks: Investments in sectoral fund schemes or theme-based schemes will be in stocks of select companies. If there’s any sudden adverse development in the sector, the overall fund performance will be hampered.

Liquidity risk: Securities that are thinly traded carry the danger of not being easily saleable at or near their real values. In such a case, a fund manager may find it difficult to quickly sell an illiquid stock/bond as this might significantly affect the price of the fund adversely. It must be noted that Indian fixed income market is characteristic of liquidity risk.

Changes in government policy: If the government changes its policies regarding, say import duty or taxes levied on a sector, then it will have a huge impact on the sector and the companies in that sector. This might lead to underperformance in the stocks held by you.