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At the cornerstone of investing is the basic principal that the greater the risk
you take, the greater the potential reward. Or stated in another way, you get what
you pay for and you get paid a higher return only when you're willing to accept
more volatility.
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Risk then, refers to the volatility – the up and down activity in the markets and
individual issues that occurs constantly over time. This volatility can be caused
by a number of factors – interest rate changes, inflation or general economic conditions.
It is this variability, uncertainty and potential for loss, that causes investors
to worry. We all fear the possibility that a stock we invest in will fall substantially.
But it is this very volatility that is the exact reason that you can expect to earn
a higher long-termreturn fromthese investments than froma savings account.
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Different types of mutual funds have different levels of volatility or potential
price change, and those with the greater chance of losing value are also the funds
that can produce the greater returns for you over time. So risk has two sides: it
causes the value of your investments to fluctuate, but it is precisely the reason
you can expect to earn higher returns.
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You might find it helpful to remember that all financial investments will fluctuate.
There are very few perfectly safe havens and those simply don't pay enough to beat
inflation over the long run.
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Types of Risks
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All investments involve some form of risk. Consider these common types of risk and
evaluate them against potential rewards when you select an investment.
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1. Market Risk – At times the prices or yields of all the securities in a
particular market rise or fall due to broad outside influences. When this happens,
the stock prices of both an outstanding, highly profitable company and a fledgling
corporation may be affected. This change in price is due to "market risk". It is
also known as systematic risk.
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2. Inflation Risk – It is sometimes referred to as "loss of purchasing power."
Whenever inflation rises forward faster than the earnings on your investment, you
run the risk that you'll actually be able to buy less, not more. Inflation risk
also occurs when prices rise faster than your returns.
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3. Credit Risk – In short, credit risk evaluates the following – how stable
is the company or entity to which you lend your money when you invest? How certain
are you that it will be able to pay the interest you are promised, or repay your
principal when the investment matures.
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4. Interest Rate Risk – Changing interest rates affect both equities and
bonds in many ways. Investors are reminded that "predicting" which way rates will
go is rarely successful. A diversified portfolio can help in offsetting these changes.
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5. Exchange Risk – A number of companies generate revenues in foreign currencies
and may have investments or expenses also denominated in foreign currencies. Changes
in exchange rates may, therefore, have a positive or negative impact on companies
which in turn would have an effect on the investment of the fund.
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6. Investment Risks– The sectoral fund schemes, investments will be predominantly
in equities of select companies in the particular sectors. Accordingly, the NAV
of the schemes are linked to the equity performance of such companies and may be
more volatile than a more diversified portfolio of equities.
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7. Changes in the Government Policy Changes in Government policy especially
in regard to the tax benefits may impact the business prospects of the companies
leading to an impact on the investments made by the fund.
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8. Effect of loss of key professionals and inability to adapt business to the rapid
technological change – An industries' key asset is often the personnel who
run the business i.e. intellectual properties of the key employees of the respective
companies. Given the ever-changing complexion of few industries and the high obsolescence
levels, availability of qualified, trained and motivated personnel is very critical
for the success of industries in few sectors. It is, therefore, necessary to attract
key personnel and also to retain them to meet the changing environment and challenges
the sector offers. Failure or inability to attract/retain such qualified key personnel
may impact the prospects of the companies in the particular sector in which the
fund invests.
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