How can you Mitigate the Risk of Investing in Mutual Funds?

Risk in mutual fund comes in different forms. For example, there is market risk and there is company specific risk when you invest in equity funds. There is a risk of cyclicality in sector funds and thematic funds. Then there is a price risk in debt fund if the yields rise, especially when the fund has a longer maturity. Even in the case of liquid funds, there is a risk because all short term bonds above 1 month need to be marked to market. Under these circumstances, how do you mitigate your risk of investing in mutual funds? Here is a 6-point primer.

1. Diversification is still the golden rule in mutual funds

You may have heard this before but it is worthwhile hearing it again. Diversification is all about spreading your risk. You must diversify across asset classes. Within equity funds, you must diversify across sectors, themes and capitalizations. That is why a diversified fund or a multi cap fund is more suited to your risk than a sector fund or thematic fund. When it comes to debt funds, diversify across maturities and credit opportunities.

2. Fund houses with pedigree make you less prone to disruptions

In the last few years, we have seen debt funds getting into trouble when the bond got downgraded. This was the case with Amtek Auto bonds and much later with IL&FS bonds. That is where size and pedigree matters. Larger funds with a bigger AUM are better equipped to absorb such volatility in the market compared to small funds. Quite often, small funds may look optically elegant with better returns but there is a risk aspect because such funds are more vulnerable.

3. Phase your investments rather than clustering them

We know this approach popularly as systematic investment plans (SIPs). These SIPs not only give you the benefit of rupee cost averaging but also help in reducing your overall cost of holding over time. Even if you have a lump sum to invest, you have techniques like the systematic transfer plans (STP) where you can phase out your lump sum corpus. Over longer periods of time, such a phased approach to investing in mutual funds works a lot better than trying to estimate the tops and bottoms of the market.

4. Don’t go by the crowd mentality when investing in mutual funds

The herd mentality is more common in equity investing but investors often make the same mistake while investing mutual funds too. A classic case in point is the new fund offerings (NFOs). Firstly, NFOs are not like IPO because an NFO will just invest the money in the existing market conditions. So you can be indifferent between an NFO and an existing mutual fund. Also, most NFOs try to ride on sectoral and thematic waves and you are likely to end up buying such themes at the peak. Such NFOs are best avoided.

5. Evaluate funds on risk and consistency

Every fund prospectus mentions that past returns are not indicative of future returns. But, when it comes to evaluating a fund, you don’t have much of a choice. But, you can improve upon this pure returns approach. Firstly, look at consistency. Even if returns of two funds are the same over the last five years, focus on funds that have been more consistent year on year. Such funds are more predictable and the timing of entry does not really matter. Secondly, look at returns with reference to risk. Returns of 14% with 20% standard deviation are better than 16% returns with 50% standard deviation. Get that perspective right!

6. Finally, every mutual fund investment must have a purpose; and that is your goal

The best way to de-risk your mutual fund purchase is to link them to goals. Once your long term goals like retirement or child’s education are known, just select the appropriate fund and tag the Sip to that goal. The result is that, at any point in time, you know where your investment stands vis-à-vis your goals and your intermediate goalposts. That is your best bet to mitigate the risk of mutual fund investing.