When it comes to investing in mutual funds, risk and returns are like two sides of the same coin—you can’t do without it. Moreover, deciding the amount of risk you are willing to take comfortably with your investments is extremely critical as it will help you take crucial decisions while investing. The risk-return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return.
It is for this reason that low risks are associated with low potential returns and high risks are associated with high potential returns. A common mistake which is made by most investors is to generalise the relation between risk and return to be directly correlated—higher the risk, higher the return or lower the risk, lower the return.
As an investor, you need to be aware that higher risk does not always mean higher returns. While the risk-return trade-off indicates that higher risk gives you the probability of higher returns, there are no such guarantees. The fact remains that a higher potential returns could also lead to higher potential losses.
Measuring risks Practically, risk means you have the possibility of losing some or even all of your original investment. On the lower end of the risk scale is a measure called the risk-free rate of return, usually represented by the yield on a one year Treasury bill, which is 6.99 per cent as on June 20, 2016. This risk-free rate is used as a reference for equity markets and in case of debt markets, the overnight repo rate is used. This means if the current risk-free rate is 6.99 per cent, there is virtually no risk and you can earn 6.99 per cent per year. Technically, risk is measured in statistics by standard deviation, which is the ratio that measures how a fund is performing.
A more practical way is to check what risk category a fund scheme falls under based on its Riskometer. With the Riskometer, you can determine the risk level—‘low’, ‘moderately low’, ‘moderate’, ‘moderately high’ or ‘high’ and select a fund that meets your needs.
olmdesk@outlookindia.com