Investors often enter the equity market without understanding the risks. Such investment carries systemic risks, irrespective of whether one opts for direct exposure or through mutual funds. Here is a way to evaluate such risk.
To achieve financial goals, the first evaluation is the risk-taking capacity of the individual. People tend to take higher risks early in their career. Later on their risk-taking abilities are limited due to the lesser number of earning years.
The fewer earning years ahead limits the latter’s risk-taking ability even if the individual is very keen to achieve investment goals.
If individuals are unable to understand and assess their risk appetite, it may not be wise to hold risky assets such as equity.
Risk perception: Let us say that the risk perception of investors vary between 1 and 100 per cent. For someone in his 20s, equity may mean losing as much as 40 per cent of investments, while for his father, a 10 per cent decline could mean a high-risk strategy. This perception arises from one’s ability to tolerate risk.
Another key issue in which investors often falter is the nature of funds. Take the example of an investor who made his money in the derivatives market in 2007; this prompted him to use his father’s retirement corpus (earmarked for the investor’s sister’s wedding) in a high beta mutual fund, which fell by over 50 per cent in a downturn.
Two lessons emerge from this case: one, funds with a crucial financial goal in the near future cannot be exposed to market vagaries. Two, transfer of risk to a younger person does not automatically mitigate the risk of investing in equity.
The final step of evaluation is risk tolerance. If you cannot stomach losing money don’t barge into the equity market. If you are ready to lose at least 20-30 per cent, then you can consider mutual funds.
Risk tolerance: We come across advisors recommending MIPs to retired people as part of portfolio diversification. The advisor might know the risk profile of the investment but investor understands the risk only when he losses money.
To understand how it is possible to lose money without understanding the risk tolerance, we analysed the performance of monthly income plans (which invest about 80 per cent of the money in debt schemes and rest in equity).
The perception among individuals is that monthly income schemes declare dividends every month. Some investors enquire during market downturns why their MIPs are not declaring dividends. For instance, if an individual had invested in an MIP in January 2008, the one-year category average return of the scheme would have been minus 8 per cent.
The disparity between the best in the category and the worst was wide. The best generated a 20 per cent return in one year ending January 2009 while the worst lost 12 per cent. If you had invested in the scheme without understanding your risk tolerance and sold the units in loss in panic, your tolerance for risk was low.
Had the person stayed invested during the market correction, the fund would have once again moved to positive territory.
For instance if you look at a one-year period ending September 29, the best performing Reliance Monthly Income Plan generated a return of 30 per cent while, for the same period FT India Monthly Plan (Bonus) lost 3.5 per cent.
This shows that before investing one has to evaluate the risk-taking capacity, perception and tolerance towards risk to accumulate money in an asset class such as equity.
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