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- Weigh mutual fund investment risks in terms of potential returns
- Higher the risks greater are the chances of more returns and vice-versa
In broad terms, risk can be defined as the exposure to some amount of danger or possibility of loss or injury. In the context of investments risk often refers to the chance an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of original investment.
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Basics of Risk
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways and investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.
Risk and Time Horizons
Time horizon and liquidity of investments is often a key factor influencing risk assessment and risk management. If an investor needs funds to be immediately accessible, they are less likely to invest in high-risk investments or investments that cannot be immediately liquidated and more likely to place their money in riskless securities.
Time horizons will also be an important factor for individual investment portfolios. Younger investors with longer time horizons to retirement may be willing to invest in higher risk investments with higher potential returns. Older investors would have a different risk tolerance since they will need funds to be more readily available.
Risk vs. Reward
The risk-return trade-off is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns. Each investor must decide how much risk they’re willing and able to accept for the desired return. This will be based on factors such as age, income, investment goals, liquidity needs, time horizon, and personality.
Should one ignore the risk associated with mutual funds
Risk plays a very vital role in investment decisions. Let us illustrate this with the help of an example.
Here is an example: Mr. X is investing ₹20,000 every month to create his retirement corpus in fifteen years. When he realizes that his investments in large-cap mutual funds are unlikely to help him to achieve his target, he decides to start investing in small-cap mutual fund schemes. He reasons that his large-cap investments will offer him only around 10-12 percent in 15 years, whereas small-cap schemes have the potential to give around 15 percent.
He doesn’t see anything wrong with his approach because otherwise he would be far away from his target corpus at the time of retirement after 15 years. Is he right?
Sadly, many investors would show themselves way out the door and many would swear they would never return to equity mutual funds. Clearly, they understood the real meaning of risk by then. That is the reason why most mutual fund advisers and financial planners keep drumming the point: always choose investments that match your risk profile and investment objectives.
The writer of this post is Nikhil Sapra, he is a team leader in Mutual Funds division at Wishfin
Disclaimer – “Mutual Fund investments are subject to market risks. Please read the scheme document carefully before investing.”