8 Ways to Reduce Mutual Fund Investment Risk

Updated on 17 Oct, 2023

Reviewed by

Fact checked by

6 Mins

Risk and reward are two sides of the same coin when it comes to investing. The usual mindset it that to earn higher returns, one needs to take high risk. However, unfortunately, the vice versa doesn’t hold – taking a high risk doesn’t necessarily give you high returns. Taking high risk is not a bad thing, but employing tricks that can help mitigate investment risk is necessary.

Design and Align Portfolio with Risk Appetite

Mutual Fund investments are made based on investors profile. Risk varies among investors. What is a good fund for one person might not be the best for another person. While choosing a fund one has to consider their age, financial position, number of dependents, the duration for the goal, and risk tolerance. For instance, if an investor has a moderate to high-risk appetite and has a long term investment horizon, then equities would be the best-suited fund. While for a low-risk appetite investor, debt funds would be the best-suited category. Therefore, do not invest based on word of mouth recommendations, make sure you are aligning the funds with your risk appetite.

SIP Investing for all Your Regular Savings

Be it any market phase, investing through SIP is always beneficial. SIPs keep you a disciplined investor and are very easy to monitor. It takes advantage of rupee cost averaging. Without worrying about timing the market, SIPs help in averaging the cost over time. More units are bought for the same amount when the prices are low and fewer units when the prices are high. Therefore, it is advised to invest in Mutual Funds through SIPs and not worry about overvalued markets.

STPs for Lump Sum Investments

Rather than worrying about overpriced markets while investing lump-sum amounts, systematic transfer plan (STP) is the best option available. Similar to SIPs, STPs also take advantage of rupee cost averaging. By averaging out the buying cost, investors can relax about overvalued markets. STP is also useful when your long term financial goals are nearing maturity. Shifting the funds from equity to ultra short term debt funds will help in consolidating gains by reducing the downside risk.

Asset Allocation

The key to asset allocation is to balance the risk and reward. Asset allocation involves investing in various asset classes like equities, mutual funds, debts, real estate, and gold. One should choose the right assets based on their financial goals. Duration of your goal will help in deciding on the asset class. For short term goals, debt funds are ideal. While for long term goals equities are ideal. Therefore, based on the duration and your risk appetite, the right asset class should be chosen for investment.

Diversify Your Portfolio

As the saying goes, do not put all eggs in one basket, do not have all your investments in the same asset class and also in the same instrument of an asset class. A common practice has been to invest in a fund that has been performing well in the near past. It ultimately increases market risk. In case the market falls, and your investment in the fund is negatively affected, you are at risk of losing most of your money. Therefore, it is always advisable to have exposure to multiple asset classes and also various sectors or types in the same asset class. It helps in lowering the concentration of risk. If any one fund underperforms, there is always another fund that will make up for the loss.

However, investing in too many funds may lead to the overlapping of themes and sectors. Thus, you need to be mindful of the portfolio allocation of the funds that you invest. Ensure your funds are not investing across the same securities.

Hire Investment Advisor

Investing has become convenient with the availability of various fintech apps. However, the abundance of financial information can lead to confusion, making it difficult for novice investors to make informed decisions. Many investors are unaware of goal-based financial planning and end up making ad-hoc investments based on tips from friends and family or the media, which can be detrimental to their financial well-being. Investing should be personalized based on an individual’s financial situation, needs and goals.

An investment advisor can provide assistance in creating a holistic investment plan, determining an appropriate risk profile, and making sound investments based on age, financial goals, and income. Therefore, it is vital to seek the advice of an unbiased investment advisor.

Ensure Adequate Liquidity to Deal with Emergencies

While there are financial risks with investing, there are also non-financial risks that can affect the performance of your portfolio. For example, unexpected expenses or emergencies can arise that require a large lump sum payment at short notice. If your funds are locked into long-term investments such as mutual funds, you may have to sell them at an inopportune time, sacrificing potential returns.

To guard against this risk, it’s a good idea to establish an emergency fund that comes in handy in dire situations without disrupting your long-term investments. This emergency fund should be invested in schemes that are not affected by market fluctuations, such as liquid or overnight funds with instant redemption options. Allocating about 10% of your overall portfolio to such schemes is advisable. Keeping the remaining corpus in other products can prepare you for unexpected events.

Move to Safer Investment Options Once You Achieve Your Goal

If you achieve your financial goals earlier than expected, it may be wise to shift your investments to a more conservative fund to protect your capital. For example, if you have invested aggressively in equity and have reached your goal, you can reduce the risk level by moving some of your investments to a debt fund. Or balanced advantage fund, where the allocation between equity and debt is managed dynamically to mitigate risk. Continuing to invest in an equity fund after reaching your goal can be risky due to market volatility. Hence it’s important to transfer the corpus to an investment with lower risk.