As you begin your journey as an investor in Mutual Funds, you will realize that a solution that works for another person may not work for you.
The suitability of a product in other words depends on the characteristics of the investor.
As an investor you may have different investment goals. The time you want to stay invested, ability to tolerate risk, minimum investment amount, etc. all differ for every goal.
In this note, we will explain the key role that risk plays in determining which investment is to consider based on your investment goals and risk appetite.
What are the types of risk:
Mutual Funds are subject to many kinds of risks some of which we’ve detailed below.
| Type of Risk | Impact on the Fund |
|---|---|
| Liquidity Risk | The fund can’t liquidate its investments because there are no buyers |
| Market Risk | Unavoidable risks affect the entire market and so the value of the fund’s investments have also declined as a result |
| Interest Rate Risk | The value of Fixed Income Securities declines when interest rates rises |
The level of risk in a mutual fund depends on what it invests in.
Equity fund tends to be riskier than a fixed income fund. Yet the greater the risk, the greater the reward (or potential for higher returns), so it really depends on your appetite for risk or your risk profile.
How do I know my risk profile?
Risk profiling helps an investor to create a specific investment portfolio with an asset mix correlating to his risk profile. Risk required is the risk associated with the return required to achieve your financial goals.
Risk Capacity is the level of financial risk you can afford to take.
Risk tolerance, on the other hand, refers to an investor’s willingness to take or ‘tolerate’ risks or the level of volatility in returns one is ready to deal with. To evaluate your ability to take on risks, the first step is to understand how long you have to invest, so you can make informed investment decisions that reflect your individual circumstances.
The table and illustration is for explanation purpose only.
An easy way to find your risk tolerance is to think of how you would react if your portfolio declines by over 20%.
If you find you are too conservative or if you are closer to retirement, it is advisable for you to seek fixed income instruments or liquid fund which is safer and has potential moderate level of returns.
If you are just starting out in your career and is someone seeking a high capital appreciation, then consider investing in an equity mutual fund.
However, even in the most conservative investment portfolio, a portion of assets should still be allocated in the stock market to protect the investor from the impact of inflation.
In both cases, being well-acquainted with your goals and the timeframe you have is a good starting point to assess the level of risk you’re comfortable with taking on.
Securities and Exchange Board of India (SEBI) has mandated mutual funds to depict the product labelling to highlight the risk level of the respective scheme so the investor can identify and makes investments in mutual fund schemes that correspond to the investor’s risk profile. The product labelling of mutual funds is based on the concept of ‘Riskometer’ and this meter depicts the level of risk in any specific mutual fund scheme.
Traditionally, the Riskometer depicted five risk areas – Low, Moderately Low, Moderate, Moderately High and High Risk. Going forward, there will be a new risk area for the MF schemes. SEBI, based on the recommendation of Mutual Fund Advisory Committee (MFAC), has reviewed the guidelines for product labeling in mutual funds and has decided to introduce, ‘Very High Risk’ as the sixth risk profile for the MF schemes.
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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.