Mutual Fund Unlocked: Measuring Risk in mutual fund investment

For mutual fund investors, risk has been traditionally defined by some of the most common indicators such as alpha, beta, r-squared, standard deviation and Sharpe Ratio. These statistical measures use the historical data to arrive at the risk-reward ratio of a mutual fund investment including mutual funds.

In addition to the above traditional measure, there are also some modern ways of calculating risk in your investment. One of them being is value at risk (VaR). It is a statistical technique that measures the potential loss that could happen to your investment over a period of time. There are primarily three factors around which VaR revolves first is the amount of potential loss, second the probability of incurring that loss and finally the time frame within which such loss can happen.

For example, VaR of 1.5 per cent at 97 per cent confidence over 3 days indicates that the portfolio value will not depreciate more than 1.5 per cent over the next 3 days and the confidence or certainty of this event is 99 per cent. The confidence level is a reliability measure that expresses the accuracy of the result. A confidence level of 95 per cent means that on 5 out of 100 trading days, the VaR would exceed the calculated maximum loss. Usually, VaR is calculated for a time horizon of one day, one month or one year, which means the maximum losses that an investor can incur at the end of a particular period.

There are mainly three methods to calculate VaR- analytical, historical simulation and Monte-Carlo simulations. Although, it is hardly used by mutual fund investors to measure their investment risk, however, we believe if it is used along with other risk management techniques such as scenario analysis and sensitivity analysis, it can provide a robust risk management framework for investors.

Many investors tend to focus exclusively on investment returns with little concern for investment risk. A proper risk assessment will help investors to manage their financial planning in a better way.