Risk-returns ratio

The discussion on investment objectives would not be complete without a discussion on the risks that investing in a mutual fund entails.

At the cornerstone of investing is the basic principle that the greater the risk you take, the greater the potential reward. Remember that the value of all financial investments will fluctuate.

Typically, risk is defined as short-term price variability. But on a long-term basis, risk is the possibility that your accumulated real capital will be insufficient to meet your financial goals. And if you want to reach your financial goals, you must start with an honest appraisal of your own personal comfort zone with regard to risk. Individual tolerance for risk varies, creating a distinct "investment personality" for each investor. Some investors can accept short-term volatility with ease, others with near panic. So whether you consider your investment temperament to be conservative, moderate or aggressive, you need to focus on how comfortable or uncomfortable you will be as the value of your investment moves up or down.

Recognizing the type of investor you are will go a long way towards helping you build a meaningful portfolio of investments that you can live with. Take the test "Tolerance Questionnaire" to determine where your preferences lie.

 

 

Managing risks

Mutual funds offer incredible flexibility in managing investment risk. Diversification and Automatic Investing (SIP) are two key techniques you can use to reduce your investment risk considerably and reach your long-term financial goals.

Diversification


When you invest in one mutual fund, you instantly spread your risk over a number of different companies. You can also diversify over several different kinds of securities by investing in different mutual funds, further reducing your potential risk. Diversification is a basic risk management tool that you will want to use throughout your lifetime as you rebalance your portfolio to meet your changing needs and goals. Investors, who are willing to maintain a mix of equity shares, bonds and money market securities have a greater chance of earning significantly higher returns over time than those who invest in only the most conservative investments. Additionally, a diversified approach to investing -- combining the growth potential of equities with the higher income of bonds and the stability of money markets -- helps moderate your risk and enhance your potential return.

Systematic Investment Plan (SIP)


The Unitholders of the Scheme can benefit by investing specific Rupee amounts periodically, for a continuous period. Mutual fund SIP allows the investors to invest a fixed amount of Rupees every month or quarter for purchasing additional units of the Scheme at NAV based prices.

Here is an illustration using hypothetical figures indicating how the SIP can work for investors:

Suppose an investor would like to invest 1,000 under the Systematic Investment Plan on a quarterly basis.
  Amount Invested () Purchase Price () No. of Units Purchased
Initial Investment 1000 10 100
1 1000 8.20 121.95
2 1000 7.40 135.14
3 1000 6.10 163.93
4 1000 5.40 185.19
5 1000 6.00 166.67
6 1000 8.20 121.95
7 1000 9.25 108.11
8 1000 10.00 100.00
9 1000 11.25 88.89
10 1000 13.40 74.63
11 1000 14.40 69.44
TOTAL 12,000 - 1,435.90
 

Average unit cost Rs 12,000/1,435.9 = 8.36

Average unit price 109.6/12 = 9.13

Unit price at beginning of next quarter 14.90

Market value of investment 1435.9 * 14.90= 21,395/-

The investor liquidates his units and gets back 21,395/-

Using the SIP strategy the investor can reduce his average cost per unit. The investor gets the advantage of getting more units when the market is turned down.

Types of risks

All investments involve some form of risk. Even an insured bank account is subject to the possibility that inflation will rise faster than your earnings, leaving you with less real purchasing power than when you started (1000 gets you less than it got your father when he was your age). Consider these common types of risk and evaluate them against potential rewards when you select an investment.

Market Risk

At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk".

Inflation Risk

Sometimes referred to as "loss of purchasing power." Whenever inflation sprints forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.

Credit Risk

In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?

Inflation Risk

Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offseting these changes.

Effect of loss of key professionals and inability to adapt

An industries' key asset is offen the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers.

Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.

Exchange Risk

A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.

Investment Risk

The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.

Change in the Government Policy

Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund.

 
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