Understanding risk when investing in Mutual Funds

In cricket, when a batsman has to choose between scoring or defending, one of the important factors they assess is the risk of losing a wicket. If trying to score involves a high risk of losing a wicket, the batsman would most likely defend the delivery. This human behaviour of assessing risk and reward is not limited to cricket. It’s prevalent across most spheres of life — be it driving a car, crossing a busy road, or making business decisions.

Strangely, when it comes to investing, many tend to make their investment choices based purely on returns. As per AMFI’s data, in 2020 and 2021, investors went after Technology and Pharma funds, after their strong performance in 2020. Likewise, Small Cap funds turned out to be investors’ favorite in 2022 after their stellar performance in 2021.

Several investor surveys also indicate that return is the primary parameter most retail investors rely on to decide which fund to invest in. Investors hardly pay heed to understand the risk characteristics of the fund or the category the fund belongs to.

Why do investors focus only on returns, and not risk?

Since the final outcome of an investment is the returns, it is natural for investors to focus more on the returns than any other deciding factor. Additionally, it is also easy for investors to track returns — making it a more popular factor to check before investing.

That being said, assessing risk in Mutual Funds is no child’s play. The framework that is currently being used to arrive at risk ratings of funds (typically depicted with the riskometer in fund literature) shows the same risk rating for funds across different categories. For example, many funds across categories such as large-cap, flexi-cap, midcap, small-cap, thematic, etc. end up having the same “Very High” rating. Also, other risk parameters such as standard deviation, beta, etc. may seem complex for investors to understand. Thus, similar risk ratings for different funds and the complexity of deeper assessments could be a few reasons why investors skip risk assessment when investing in Mutual Funds.

However, it is not the best practice to invest without assessing the risk characteristics of the fund or category. In fact, as part of fund selection, it is extremely critical for investors to identify the fund categories that are aligned with their own risk appetite.

Using the Drawdown metric to assess risk associated with fund categories

Drawdown is the maximum drop in an investor’s investment value, which is intuitively easy to understand from an investor’s perspective.

The table below shows (a) the maximum drawdown and (b) percentage of investors that have witnessed more than 20, 30, 40, or 50 percent drawdown for some of the key categories:

A drawdown metric, such as the one above, can provide clarity to investors on what kind of risk/drop in value their investments can experience when they own such funds.

Example: The worst drop for the small-cap category is -77.14 percent whereas the large-cap category sees a drop of -59.50 percent. Also, more than 20 percent of investors have seen a drawdown of over 50 percent in small-cap funds, whereas only 2.65 percent of the investors in large-cap funds have experienced drawdowns of such magnitude.

An investor can look at such drawdown statistics and choose a category that aligns with their risk-taking ability.

Remember, investing in Equity Funds requires patience to hold onto your investment for the long term. Not being comfortable with the drawdown you witness in a fund can often make it extremely difficult to stay invested. Following a data-based risk assessment approach can go a long way in smoothening your wealth creation journey.

The author, Nilesh D Naik, is Head at Mutual Funds, PhonePe