INVESTORS NEED TO understand risk, not only to identify their own risk profile but also to select the correct asset allocation and mitigate any potential threats. Risks in mutual funds can be classified under two major categories—systematic risk and unsystematic risk.

Systematic risk
It is caused by factors that are beyond the control of a specific company or individual and can cause severe damage to an investor’s portfolio. Multiple macroeconomic factors are at play here, resulting in changes in the expected returns of the entire market. Three of the key systematic risks include:

Market risk: When a particular risk has the potential to affect the entire market (and not just a particular industry or company), it is referred to as market risk. Panic induced in investors by unforeseen events can result in herd mentality.

Interest rate risk: Depending on the credit available with the lenders and the demand from borrowers, interest rates keep changing and they are inversely proportional to each other. Investors can safeguard their investments by holding bonds of different durations.

Inflation risk: It refers to a situation wherein the performance of an investment or the value of an asset may be adversely affected by inflation in the broader market. The future real value (after inflation) will be impacted due to a potential rise in the cost of production.

Unsystematic risk
Situations like changes in government policies, rise in competition, change in consumer taste and preferences, technological changes, etc., can impact the performance of a company. Some of the types of unsystematic risk are:

Business risk: Only those with a sound business model that is built on the foundation of technology and have the ability to invest in innovation and customer experience will emerge as winners in the future.

Credit risk: A particular borrower may fail to meet contractual obligations or even pay off the intended loan. As a ‘borrower’, you run the risk of the lender’s debt obligation. The ‘issuer’ is at risk since you may not be able to honour your commitment.

Reputation risk: Valuation of a company drops instantly after a campaign goes downhill or the senior management quits unceremoniously. These reputational risks can have a big impact on the business, causing investors to lose faith in it.

What can retail investors do
Volatility and risk are key drivers of the investment landscape. Volatility can become a friend of long-term investors by allowing them to leverage wealth creation market opportunities (buy in lows). Risk can be mitigated through careful diversification across equity, fixed income, hybrid and further widening the scope by opting for actively or passively managed funds.

The writer is chief business officer, Axis AMC