Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict what will happen in the future or whether a given asset will increase or decrease in value. Because the market cannot be accurately predicted or completely controlled, no investment is risk-free.
What Is Market Risk?
Market risk is the risk inherent in all types of investments that results from the fickle nature of the market and of the global economy in general. Market risk is simply the possibility the market or economy will decline, causing individual investments to lose value regardless of the performance or profitability of the issuing entity. For example, in the stock market crash of 2008, nearly every stock lost value despite the fact most companies had not done anything wrong or altered their operations in any way. The result could not have been predicted or prevented by any one company.
Types of Market Risk
There are many components of market risk that apply to different types of investments. The common types of market risk are equity risk, interest rate risk, credit risk, inflation risk, sociopolitical risk and country risk. Some types of investments are susceptible to multiple types of market risk. The type of market risk that applies to mutual funds depends on the assets held in its portfolio.
Equity risk applies to investments in the stock market and refers to the risk that changing prices in the stock market may render an individual investment less valuable when the owner wants to sell. This type of risk applies doubly to stock funds. First, the value of mutual funds can fluctuate, causing shareholder investment to lose value. In addition, the value of stock funds is dependent entirely on the market value of portfolios comprised solely of stocks, which in turn are also subject to equity risk. Equity risk also applies to balanced funds that include stock investments.
Interest rate risk applies to investments in debt securities, such as government and corporate bonds. This type of risk relates to the possibility that rising interest rates, as dictated by the Federal Reserve, will render current bonds less valuable. This type of risk impacts bond funds, money market funds and balanced funds. Credit risk, or the risk a bond issue will default, also applies to bond funds. (For related reading, see "Managing Interest Rate Risk.")
Inflation risk, as the name implies, is the risk that gradual inflation will erode the value of the dollar and reduce the value of long-term investments. Inflation risk is primarily an issue for money market funds because their returns are so low they could easily be outstripped by inflation over time.
Sociopolitical risk refers to the possibility that events such as war, acts of terror or political elections may have a negative impact on the market in general. Similarly, country risk refers to the same phenomena but only when applied to events that impact investments in foreign countries. Depending on the specific product, these types of market risk can apply to any mutual fund because they impact the U.S. or foreign markets in general, which in turn affect the equity and debt assets within a fund's portfolio.
(For related reading, see "5 Ways to Measure Mutual Fund Risk.")