A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.
Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.
The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.
If mutual funds diversify risk, why are they considered risky?
Mutual funds invest in securities, whether stocks or debt, whose values fluctuate along with market movement. This makes them risky because the fund’s NAV depends on the individual safety values held in the fund’s portfolio. But because mutual funds invest in securities in different sectors, they diversify this market risk. Because a fund invests in many stocks, the risk of all of them falling in value on any given day is small. Therefore, it is true that mutual funds diversify risk, but do not eliminate it. The diversification followed by a fund manager reduces the market risk of the fund to the extent of diversification. The more diversified a fund is, the less risky it is.
Concentrated funds such as thematic or sector funds are riskier than multi-cap funds will impact all companies in the affected sector in one way or another, while in a multi-cap fund, diversification between sector and capitalization works like an airbag during a car accident, reducing the impact of the unfavorable condition on the fund’s NAV.
When investing in mutual funds, look at the degree of diversification in the fund’s sector allocation. Depending on your risk-taking ability, choose a fund with the right kind of diversification that suits you.