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The risks of investing in mutual funds
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Saxo Group
Mutual funds are usually considered an investment opportunity that helps you lower market risk with diversification, but it is important to remember that they aren’t risk-free.
Here is a list of risks investors should be aware of:
- Market risk: This is the risk that a mutual fund's value will decrease due to poor choice of holdings and/or broader market fluctuations. The maximum loss a client can face when trading mutual funds is dependent on the amount invested and the performance of the mutual fund. If all the fund’s holdings go to 0, it is possible to lose the entire invested amount. However, most mutual funds are diversified and this scenario is typically unlikely.
- Liquidity risk: Imagine you want to sell your old car, but there aren’t many buyers in the market. You might have to lower your price or wait a while to find a buyer. This scenario illustrates liquidity risk, which means some assets are hard to sell quickly without losing value. Liquidity risk also affects certain mutual funds that invest in such assets. For instance, a mutual fund holding exotic investments may need to sell them at a discount or wait until buyers are willing to pay the desired price. The difference between the buying and selling price of an asset is called the spread, and it is typically larger for illiquid assets than for liquid ones.
- Currency risk: This is the risk that affects a mutual fund investing in foreign companies. For instance, consider a French-based mutual fund that invests in an American company like Apple. If the USD depreciates relative to the Euro, the value of the Apple position decreases, negatively impacting the portfolio’s performance.
- Leverage risk: Certain mutual funds known as complex mutual funds use leverage, (i.e., borrowed money) to control larger positions than they could otherwise. Leverage allows a fund to amplify its returns, but it also magnify losses. The greater the leverage, the higher the risk.
Depending on the specific type of mutual fund, there may be additional risks such as interest rate risk, credit risk, or geopolitical risk. It’s essential to review a fund’s documents to thoroughly understand the specific risks associated with the fund.
If you are ready to invest in mutual funds, check out our fourth and final chapter to find out what to look for when choosing mutual fund.
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