Why You Should Consider Risk-Reward While Investing in Mutual Funds?

January 31, 2023 Mutual Fund

Risks are inevitably associated with investments. For example, while mutual funds provide benefits such as wealth creation and diversification to investor’s portfolio, they also carry significant risks. The wisest choice an investor can make to reduce mutual fund risks is to learn more about them and practise strategies for mitigating them.

However, most investors begin investing in mutual funds by assessing their past performance. They consider returns as a yardstick to evaluate or compare a mutual fund with its peers. You see, the performance alone may not be sustained on a long-term basis due to the prevailing uncertainty in the markets. It is of paramount importance that investors should also consider the risk that mutual funds will expose them to, after all, risk and return are two sides of the same coin. That’s why, when it comes to investing, it is important to evaluate returns more meaningfully by assessing the risks involved. Remember that in mutual fund investments, higher returns are generally associated with higher risk.

What are the risks associated with mutual funds investment?

In a broader sense, mutual fund risk can be categorised as – systematic risk and unsystematic risk. Below are the various types of risks that mutual funds as an investment vehicle inherits.

• Market Risk – Since your returns are entirely reliant on the market, market risk is the first and foremost risk for mutual funds. Simply put, market risk refers to the possibility that the economy or market may weaken, causing individual investments to lose value regardless of its performance. While a bullish market will generate sizeable returns, a bearish market may result in negligible gains or even losses. 
• Inflation Risk – It is the risk where one loses purchasing power, mainly due to the rising inflation rate. Typically, investors are exposed to the impact of this risk when the rate of returns earned on investments fails to keep up with the increasing inflationary rate. For instance, if the rate of returns is 10% per annum and the rate of inflation is 6%, then investors are left with only 4% as net returns from their investments. This is also known as the real rate of return.
• Interest Rate Risk – It deals with the risk of rising interest rates and their effects on bond prices. A significant factor is the well-known inverse link between bond prices and interest rates. In other words, the cost of the debt instrument will fluctuate if the interest rate does. For instance, the price of bonds lowers and the value of bonds similarly decreases when the interest rate rises. The main connection here is with debt mutual funds. Investors are plagued by interest risk throughout the investment horizon in the form of fluctuating interest values in mutual fund investments.
• Credit Risk – In the case of debt funds, typically, fund managers include investment-grade securities with high credit ratings. The fund manager does, however, include lower credit-rated securities to increase the pace of returns. This action frequently increases the likelihood of not receiving the promised payment. The inability of the scheme’s issuer to pay the interest that was promised is referred to as credit risk. A bond may become worthless if the issuer is unable to pay it back.
• Concentration Risk – Concentrating and investing heavily in one sector is also very risky. It can be described as a situation when investors tend to put all their money into a single investment scheme or in one sector. Investing entirely in stocks of a single sector often bears a substantial risk of losing capital if caught amidst bad market situations.
• Liquidity Risk – The inability to redeem an investment without suffering a loss in the value of the instrument is referred to as liquidity risk. The lock-in period for ELSS in mutual funds may lead to liquidity problems. ETFs can be bought and traded on stock exchanges just like shares, as you may already be aware. You could occasionally not be able to sell your investments when you need to due to the lack of buyers in the market.
• Currency Risk – This relates to the risk that falling exchange rates may result in lower investment returns. To explain, it is thought that a decline in foreign currency will occur when the value of international funds rises. As a result, when converted into INR, the rate of returns will be directly decreased.
• Rebalancing Risk – Mutual fund investments are regularly monitored by fund managers, who also rebalance the portfolio when necessary. Investors are unable to precisely identify a fund’s portfolio. Although the fund may be sufficiently diversified, the investor has no influence over the rebalancing decision made by the fund manager.

However, mutual fund investors can make the most of the risk-reward arrangement by identifying the risk involved in mutual funds beforehand.

Understanding Risk-Reward Dynamics:

This relationship between risk and return is central to investing. The level of risk in a mutual fund depends on what it invests in. Every asset class, whether equity, debt, gold, or real estate, has a risk-return trade-off. Generally, among the securities in a mutual fund’s portfolio, cash and money market securities have the lowest risk, bonds and other debt securities have an intermediate level of risk, and real estate and equities are at the higher end of the risk-return spectrum. As a result, an equity-oriented mutual fund is riskier than a fixed income or debt fund. Keep in mind that high risk does not always convert into high rewards.

Consequently, the risks related to mutual fund investments can be quantified using various ratios such as Sharpe ratio, Sortino ratio, Standard deviation and Treynor ratio. Evaluating these ratios helps you to gauge the risk-adjusted returns of a scheme. Do note that risk-adjusted returns should be used to compare schemes within the same category and with comparable indices (and not apples with oranges). This will help you make an informed investment decision as you will be able to assess the scheme’s suitability to your risk profile.

Therefore, it only makes sense to consider all the risk factors before you jump into mutual funds. As you begin your journey as an investor in mutual funds, you will realise that a solution that works for a person may not work for you. The suitability of a mutual fund scheme depends on the risk characteristics of the fund.

How to effectively mitigate the impact of mutual fund risk-reward trade-off:

You may ensure that mutual fund investments match investors’ risk-taking capability and build a portfolio based on your risk profile. Factors like one’s age, financial standing, risk appetite and financial goals must be weighed before selecting a specific mutual fund scheme. Allocate investments across asset classes and sectors like debt, equities, gold etc., to balance the portfolio’s risk-reward ratio and associated market risks effectively. For instance, individuals with a long-term financial goal may find equity mutual funds more proficient because of the high risk-reward element. To meet short-term goals, investors should put their money into debt schemes for capital protection and assured returns.

You may be wondering whether you should make changes to your investment portfolio in light of recent market events. Though the risks associated with mutual funds are numerous, they can be mitigated by prudent investment planning.

As a result, while there will always be some risks associated with mutual funds, investors can mitigate the impact of these risks and keep their capital from eroding by adopting smart investment techniques that allow you to build a portfolio based on your risk tolerance, investment horizon, and, most importantly, is aligned with and works towards achieving your desired financial goals.

Happy Investing!

This article first appeared on PersonalFN here