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Mutual Funds: How To Manage Your Risks

| 11/29/2012 9:00 PM Thursday

Mutual funds are said to be a relatively lower-risk mode of investing in the markets, though of course, they are not entirely risk-free. How do investors work out these risks such that they can select the schemes that best suit them? Shashikant explains.

  • With the advancement of portfolio theory, many new measures of risk have emerged. However, often instead of helping an investor, all these risk measures create more confusion in investors' minds when they are selecting a scheme.
  • Standard deviation is the most basic tool investors can use as the first line of measurement for a portfolio's overall risk-adjusted returns.
  • The Sharpe ratio calculates the excess return a fund has earned for every unit of the risk it is exposed to. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
  • Unlike the Sharpe ratio, the Sortino ratio penalises only downside volatility. Moreover, it also takes into consideration the individual investor return expectation.

Analysing the risk of an asset remains at the heart of any investment decision. This has become more crucial after Harry Markowitz, an American economist who pioneered the work in Modern Portfolio Theory, demonstrated mathematically how diversification reduces risk. Although risk analysis is widely used by institutional investors, it can also be used by retail investors as both share the same goal of maximising their benefit against a given risk.

Risk analysis assumes greater significance while devising a portfolio or selecting a mutual fund scheme because the risk of individual stocks tend to cancel out each other at least partially, if not fully.

With the advancement of portfolio theory, many new measures of risk have emerged. Some of the important ratios that measure the risk of a mutual fund scheme are standard deviation, beta, Sharpe ratio, etc. Often, instead of helping an investor, all these risk measures create more confusion in investors’ minds when they are selecting a scheme. Here, we step in to help you understand what these measures mean so that you can take more informed decisions to select the right funds that suit your risk profile.

Standard deviation is one of the most widely and popularly used measures of risk till date. In pure mathematical terms, this measures the dispersion of the data from its mean. Simply put, the standard deviation is a measure of how much the return of a scheme deviates from its average return.

For example, if a fund has yielded monthly returns of 10, 25 and -15 per cent in the last quarter, it has an average return of 6.67 per cent and a standard deviation of 20 per cent. Compare this with another fund that has given return of 7, 8 and 5 per cent in the same period. This fund too has average returns of 6.67 per cent but with a much lesser standard deviation of 1.5 per cent. What this means is that the returns of the first fund deviate around 20 per cent from its average. Hence, going forward chances are that the fund’s returns will swing more and it will thus be more risky. Against this, the second fund has a standard deviation of just 1.5 per cent, indicating far more stable returns.

 

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