Knowing investment risks is more important than looking for best mutual funds

Since the election season is upon us, let me begin this article with a political analogy. If you look at elections over the past 30 years or so, they have been won or lost mostly due to the failures of the previous Governments rather than on vision for the future. If you are following the poll campaign of different political parties, including the ruling party, this narrative is being repeated this time too. This is not just true for India but for elections across the world e.g. US, UK etc. Even though counter-intuitive, this paradigm shows the political intelligence of the voter. Someone may have a grand vision of the future but the realistic time-bound outcomes are subject to large number of factors, which are not always within the control of the Government. Policy and administrative failures of previous Governments, on the other hand, are real and these are the risks which voters consider when casting their ballots.

Based on my interactions with financial advisors over many years, the most common question which financial advisors get from investors is how much return they will get from their investments. In my view, investors should take a different approach when making investment decisions. Investors should try to understand that risk and return are directly related and therefore, the more relevant question which investors should ask when making investment decisions is how much risk they are taking. If you understand how much risk you are taking, then you can make informed decisions and returns commensurate with the risk will follow. Going back to our election analogy, the failures of previous administrations are the risks which voters consider rather than lofty poll promises, when deciding who to elect. From an investment perspective, risks are real while expectations of certain level of returns are aspirations.

Risk has different meaning for different investors

An important point to be noted here is that different voter constituencies have differing views on different issues – what constitutes failure for some voters might be viewed as success by another set of voters. Voters cast their ballot based on their own perceptions of failures and successes. Similarly risk has different interpretations for different sets of investors. Retired investors or investors nearing retirement may view equity as a highly risky asset class, whereas a young investor at the starting stages of his / her career will view equity very differently because he / she can afford to hold on to their investments for a long period of time despite ups and downs in value. Therefore, investors should always invest according to their risk capacity.

Suggested reading: Are you risk averse – Understand your risk capacity

Risk capacity depends on investment tenor

Risk capacity is always higher for longer tenors. This is because over longer tenors, investments have more time to recover from temporary losses caused by volatility and grow in value. On the other hand, risk capacities are low for shorter tenors. The most important rule of investing is to choose asset classes based on your investment tenor.

Equity is a high risk asset class, but gives higher returns in the long term. Debt is low risk asset class, but gives lower returns compared to equity. For investment tenors of up to 3 years, low risk assets like debt mutual funds are suitable investment choices – you should avoid equity unless you have investment tenors of more than 3 years. Investors should further note that there are different risk categories even within debt mutual funds. For very short investment tenors (less than 1 year), you should invest in the lowest risk debt mutual funds e.g. overnight funds, liquid funds, ultra-short duration funds etc. For investment tenors of 1 to 3 years, you should invest in low to moderate risk debt funds e.g. low duration funds, short duration funds, medium duration funds, corporate bond funds etc.

Suggested reading: What are the best mutual funds for medium term investments

If your investment tenor is more than 3 years, you can afford to take more risks and can include equity in your investments. Hybrid mutual funds (which invest in both debt and equity) and equity mutual funds are suitable choices for investments over 3 years or longer periods. For investment tenors of 3 to 5 years, your risk capacity is moderately aggressive and hybrid funds are suitable investment options. You can invest in equity funds if your investment tenor is longer than 5 years.

Why do you need to have 5+ years tenor for equity funds?

Many financial advisors and online investment portals recommend equity funds for 3+ years tenors. As discussed earlier in this blog post, risks are real and should be informed by historical facts. The Sensex took 5 years to convincingly breach the all time high made before the 2008 market crash. Every market correction will not be like the 2008 crash. In fact, the 2008 financial crisis is a black swan event, i.e. a very rare event, but for intelligent investors the 2008 crash provides a benchmark for the worst case scenario which you should be prepared for.

If your investment tenor is more than 3 years but less than 5 years then hybrid mutual funds can be better choice, because if there is a major market correction during your investment period the debt portion of hybrid mutual funds will limit the downside risks. If your investment horizon is more than 5 years, then you can give your investment enough time to recover from major corrections by investing in equity mutual funds and earning higher long term returns.

Did you know which is better in the long run – Large cap or midcap equity mutual funds

How should you invest if you do not know your investment tenor?

We often come across situations where investors have excess funds to invest but do not know for how long. In such situations, investors should first assess whether they have sufficient funds for emergency needs. Investors should always set aside 3 to 6 months of expenses in a liquid fund to meet any emergency requirements. If you have sufficient emergency funds and you can base your asset allocation decision on your general risk appetite. Younger investors tend to higher risk appetites and their ideal asset allocation should be skewed towards equity, while older investors have lower risk appetites and therefore, should have higher allocations to debt. The 100 – Age Rule is a popular risk based asset allocation strategy. As per this rule, your equity allocation in percentage terms should be your age subtracted from 100, e.g. if your age is 35 years, your equity allocation should be 65%.

You may like to read: Simple asset allocation strategies for different risk profiles

Risk capacity versus risk tolerance

We often get confused between risk capacity and risk tolerance. Risk capacity is our financial ability to take risks, while risk tolerance is our attitude towards risk events. A person with a high risk capacity may have low risk tolerance, while a person with low risk capacity may have high risk tolerance; both investors tend to make wrong investment decisions. Risk tolerance is often very subjective and not easy to understand. Like the old idiom, the proof of the pudding is in the eating, we may not know our risk tolerance till we have faced a risk event. Less experienced investors, who have never encountered a recession or bear market, may not know how they will react when faced with such a situation. Even with experienced investors who have faced bear markets, complacency sets in subsequent bull markets and they feel the stress when market crashes again. We have seen time and time again that, investors enter in bull markets and exit in bear markets – this is risk tolerance in action.

Risk tolerance determines how you will react in volatile markets and if you do not know your risk tolerance, you are likely to cause yourself financial harm. We have seen investors putting in money in bull markets with the expectation of getting high returns and if they have low risk tolerance, they will pull money out when their investment value falls 15 – 20%. When you sell in a falling market, you are likely to suffer a permanent loss. A person with high risk tolerance, on the other hand, will remain invested even if the market falls 20% because they know unrealized losses are only notional and their investment will eventually grow in value.

If you have low risk tolerance, you will be better off investing in assets which have moderate risk profiles like hybrid funds, debt funds etc. These funds will be less volatile than equity mutual funds and therefore, during market corrections, your losses will be lower, you will be less likely to sell and more likely to remain invested for a long period of time. The longer you remain invested, the better returns you will get.

Focus on risks instead of historical returns

As we approach the end of this article, it is important to recap that you should focus on the risks instead of expected returns. Expected returns are difficult to forecast and therefore, most financial advisors mention historical returns. However, you should know that historical point to point returns can be notoriously volatile, depending on the prevailing market conditions. The maximum 3 year annualized returns of Nifty – 500 (the broader market index) in the last 10 years was 30%, while the minimum 3 year annualized returns of Nifty -500 was -3%. Some investors may want to look at average returns, but with a range so wide, average returns can be meaningless. But just in case some are interested, the average return of Nifty – 500 over the last 10 years was 12%.

Suggested reading: Return expectations from mutual funds – how important is past performance

Conclusion

We discussed in this blog post that future returns are unknown but you can be better prepared in your investment journey if you know the risk and invest according to your risk capacity / tolerance. I know many of our readers may still want to know, what returns to expect in the future. For the sake of our dear readers, I will share the best estimates of past returns across varied market conditions. Below is the average 3 year rolling returns of Nifty – 500 across different periods:-

2005 – 2010: 12%

2010 – 2015: 11%

2015 – Now: 12%

You may want to read our post, What is a reasonable rate of return from equity mutual funds and see if the points made in that article ties with the historical average rolling returns of Nifty – 500 mentioned above. While the pointers in the above mentioned article or the Nifty – 500 historical average rolling returns can serve baseline for setting expectations, what is much more important for your individual financial planning is that you should clearly understand risks in investing because your future actions will be influenced by the alignment (or lack of) of the risk profile of your investment and your risk capacity / tolerance. Your returns will depend on what actions you take - for the same fund, some investors may get 20%+ returns, while others may get negative returns. Choose your investments wisely and in case you are not able to understand the risk profile of your investment, consult with your financial advisor.