4. What is Risk?
Risk is the chance of having a negative or an unexpected outcome. Suppose you decide to start your own retail shop in your neighborhood. The biggest risk you would be facing is of business failure i.e. you aren’t able to sell any products and that you have to shut down the business. In that case, you will also lose the money you invested in renting the store and purchasing the inventory. On the other hand, there is a 50% probability that your business will flourish as it’s the only one in the neighborhood selling high-quality consumer brands. The key takeaway is that:
“Higher the risk, higher the reward”
In the Finance world, the above-mentioned statement is called a ‘risk-return tradeoff.’ This implies that if you want to take lower risk, you have to forgo the chances of earning higher return too. For example, you can keep cash at home as it’s the safest avenue but idle cash won’t earn any return either. On the other hand, if you invest in stocks in Pakistan, you will be taking higher risk as the chances of losing your funds is higher than the situation where cash was lying idle in a safe deposit box.
In general, Mutual Funds are known to have lower risk than stocks. This is primarily because of ‘diversification.’ For example, Ali invests Rs. 100 in purchasing 10 shares of Habib Bank limited. Ahmad, on the other hand, purchases 10 units of a Mutual Fund for Rs. 100. This Mutual Fund invests pooled funds from investors in 15 different stocks listed on the Pakistan Stock Exchange including Habib Bank Limited’s stock. If the stock price of Habib Bank falls today, Ali will be impacted more than Ahmad because he has invested all of his money in a single stock.
However, the level of risk in Mutual Funds varies with the type or category of the fund. For example, Fund A that invests 90% of its assets in Pakistan Stock Exchange (PSX) is riskier than Fund B that invests 90% of its assets in Government-backed debt securities.
Following are the different types of risk one may face while investing in a Mutual Fund:
- Mutual Funds that invest in securities that can be impacted by changes in political, economic or social situation of the country are prone to ‘market risk.’ For example, changes in Pakistan’s economy and political situation can impact businesses and thus, the performance of Pakistan Stock Market. Mutual Funds that have invested in PSX will also be impacted.
- As mentioned earlier, open-ended Mutual Funds are required to create new units if investors are demanding and purchase units from them if they want to sell. However, what if you want to sell units but Mutual Fund doesn’t have the money? In order to give you money, Mutual Funds will have to either keep ample cash on hand or readily sell some of the securities. What if the security the fund invested in was real estate? You must be aware that you can’t find a seller for real estate in just a few days. Well, this phenomenon is called ‘liquidity!’ The risk of not being able to sell securities and convert them to cash is called Liquidity Risk.
- : Suppose Bank Alfalah lends Rs. 1 million to Ali for 6 months so that he can set up his new business. The key risk that Bank Alfalah faces is the fact that Ali’s business may not succeed and he will not be able to return the funds. This risk is called a ‘credit risk.’ Mutual Funds also purchase various securities such as bonds that face credit risk. An event of credit default will impact the value of your units in a Mutual Fund.
- If a mutual fund has invested in a foreign currency, its value will be impacted by the exchange rate fluctuations.