Understanding Risk and Return in Mutual Funds

Investing is an essential part of wealth creation. Whether you are saving for a home, education, retirement, or financial independence, investments help you grow your money. But before you start investing, it is also important to understand two fundamental concepts Risk and Return.

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What is Risk in Investing?

Risk in investing refers to the uncertainty about the returns you might receive. It is the possibility that your investments may not perform as expected or that you might even lose money. Different investments carry different levels of risk. Here are the types of investment risks:

Market Risk refers to the risk of investment losses due to fluctuations in the overall market as it is driven by factors such as economic downturns, political instability, or changes in interest rates.

Inflation Risk is also known as purchasing power risk. It is a real risk that can impact the value of your money over time, making it harder to buy the same amount of goods and services.

Liquidity Risk is the risk that you might not be able to quickly sell an asset or security without significantly lowering its price. The potential need to drop the price to make a sale, illustrates liquidity risk.

Credit Risk is the possibility of a borrower such as a company or government failing to pay their debt obligations such as interest or principal. This risk is particularly relevant for investments in bonds, loans, or other fixed-income instruments.

Interest Rate Risk is the risk brought on by changes in interest rates that can affect the value of your investments, particularly fixed-income securities like bonds.

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What is Return in Investing?

Return is the profit you earn from your investment. It can come in different forms, such as:

Interest Income is the money you earn from investments that pay interest such as savings accounts, bonds, fixed deposits etc.

Dividend Income is the money received from company shares and serves as an additional earnings source alongside stock price gains.

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The Relationship Between Risk and Return

Risk and Return go hand in hand; higher risk can lead to higher rewards, while lower risk offers smaller rewards. Stocks are riskier but can grow wealth, whereas bonds and savings accounts provide relative stability. Your investment choice should match your goals, time frame, and risk tolerance for a balanced strategy.

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Few Key Measures to Evaluate Risk & Return

·???????? Standard Deviation shows the extent of variance of the fund's returns from its average return. A higher SD indicates more volatility and implies greater risk. If the fund’s standard deviation is higher than that of the benchmark, it means the fund's returns fluctuate more compared to the benchmark, making it riskier.

• Beta compares the fund’s movements to the overall market. A beta greater than 1 means the fund is more volatile than the market, while a beta less than 1 indicates lower volatility. A high beta suggests that the fund is more aggressive and can give higher returns but also comes with higher risk.
• Jensen's Alpha measures the excess return of an investment compared to its expected return, given its level of risk. A positive Jensen's Alpha indicates better risk-adjusted performance.
• Sharpe Ratio measures the excess performance of an investment over a risk-free asset (such as government bonds with sovereign guarantee) per unit of total risk taken. A higher SR indicates better risk-adjusted performance.

·???????? Sortino Ratio is a variation of the Sharpe Ratio, focusing on the downside risk. It considers only the standard deviation of the negative returns (downside deviation) when assessing risk. A higher Sortino Ratio indicates better risk-adjusted performance.

·???????? Downside Deviation measures the volatility of the returns that fall below a certain threshold (often the risk-free rate). The lower it is the better it is.

·??????? Upside Deviation measures the volatility of the returns that exceed a certain minimum acceptable return or threshold (often the risk-free rate). The higher it is the better it is.

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How to Manage Risk in Investments?

·???????? Understand your risk appetite and invest accordingly

·???????? Diversify across asset classes to reduce the impact of one investment on your overall portfolio

·???????? Invest for the long term and avoid panic-selling due to short-term volatility

·???????? Stay updated as markets change due to economic conditions, global events, and industry trends

Risk and return are two sides of the same coin. While you cannot completely avoid risk, you can manage it wisely to grow your wealth over time. Always invest based on your financial goals, risk tolerance, and time horizon.

Invest smartly, stay patient, and let your money work for you!

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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