Risk Management through Mutual Funds
Diversify your risks through the mutual fund route
Risk is an integral part of our lives. There is risk in even the most mundane of tasks such as driving to work each day or taking up a new project at work. Similarly, when it comes to investments, risks are unavoidable. If an asset class offers very good returns, it comes with a high risk disclaimer, on the other hand, if you seek out an investment that carries little or no risk, the returns are going to be low too.
When you have set out to achieve your long-term goals through investing, you must accept the fact that risks are a constant. Once you have assessed your own ability to tolerate the various risks you are going to be exposed to, you must attempt to enhance the value of your investment through prudent risk management. The key to investing wisely is not eliminating risk but garnering the ability to manage it. For a retail investor, one of the best ways to manage risks is by investing through the mutual fund route.
How mutual funds can help in risk management
A mutual fund is not an investment in itself, but an investment vehicle, that allows you to get a slice of various asset classes such as equity, debt and even real estate & gold. Mutual funds provide adequate diversification and an investor can easily use mutual funds to spread risks and keep his/her portfolio safe. If you choose your mutual funds carefully, they can serve as a good asset allocation tool that will help you balance your risks and maximize your returns.
Let’s take a closer look at the various risks you are exposed to as an investor and how mutual funds can help in managing them.
Volatility is a word that is synonymous with the markets, be it equities, debt or any other asset class for that matter. You cannot invest in the markets and expect that there will be no volatility at all. You can however protect yourself against it by using systematic investment plans or SIPs of mutual funds. In SIPs you put in small amounts of money at periodic intervals (weekly/monthly/quarterly).
SIPs help you stagger your investments, thus averaging out the impact of volatility, you would have felt had you invested a lump sum amount. Macroeconomic or political conditions may impact markets anytime, making them volatile. By investing in SIPs, you can be assured that you are least affected by such market cycles. Besides, the habit of regular investing in SIPs helps you create wealth over the long-term.
As an investor who has just been introduced to capital markets, it is easy to get carried away and overexpose yourself to a particular asset class. The lure of making quick gains when a particular stock/sector or asset class is performing well, may seem hard to ignore. However, by doing that you are putting all your eggs in one basket, thereby increasing your risk. In case the sector or the asset class makes a journey downhill, you will find yourself in the midst of a loss.
To avoid a situation like this, you can count on mutual funds. Diversification is an inherent feature of mutual funds which invest in carefully chosen scrips/stocks of varied sectors. Even when you are investing in sectoral or thematic funds if you are an aggressive investor, the stock picks are diversified even in the same sector. Therefore even if you find yourself in a market that is falling, the impact on your portfolio will be limited as your risks will be well diversified.
Taxation and inflation risk
Taxation and inflation are the two things you simply cannot avoid as an investor. If you do not pick investment products that beat inflation and are tax efficient, your portfolio will not perform to its maximum potential. While Public Provident Fund (PPF) is a tax-efficient option over investments like bank fixed deposits and post office deposits which are taxable, it is important to know that it still holds inflationary risk.
Mutual funds on the other hand are well positioned to tackle both of these risks. If tax savings are your primary concern, Equity Linked Savings Schems (ELSS) of mutual funds are a great option. You not only receive tax benefits on your investment amount, but also all the returns you receive from these schemes are completely tax free. Over and above, you receive the benefits of compounding as your investments are locked in for three years.
If you do not want to lock your money for three years, you can also choose diversified equity funds where you need not pay capital gains tax if you remain invested for over a year.
Debt funds too can be profitable in the long-term thanks to indexation benefits. Besides, debt funds can prove to be profitable in a falling inflation and therefore a falling interest rate scenario as bond prices and interest rates move in opposite directions. This means when interest rates are falling bond prices will rise.
Take a Quiz
Investments and risks will always go hand in hand, but if you can use mutual funds well as an investment route, you can protect yourself adequately from the many market risks. Risk management and proper asset allocation that is in sync with your financial plan, will minimize your losses and maximize your profits. Risk management is therefore considered an integral part of wealth creation over the long-term.