Risk Ladder for Equity Mutual Funds: Watch your step!

The standard deviation is the simplest way of measuring volatility of an instrument. For investors, it is, the most important risk measure they should be aware of while choosing product categories.  It is in my opinion, the key to successful mutual fund investing  and can help you select mutual fund categories suitable for your financial goals

When you calculate returns of a volatile instrument, each week, each month, or each year, it will fluctuate up and down. You can easily determine the average return over a given period. However, the individual entries can deviate from this returns. The average of such deviations, is the standard deviation. It is defined such that it is always positive, while returns can be positive or negative.

For example, if the average annual return of an equity fund over the last 10Y years, is 18%, it is tempting to expect such returns when you wish to invest in such equity funds.

However, the standard deviation tells you how much the actual return has varied from the average return.

Say, the standard deviation is 5%.

This means, in the past 10Y, the return is 18% +/- 5%. That is the standard deviation is defined as the error in the average return.

This definition assumes that the data points obey what is called a normal distribution or a bell curve. This is not often true. However, the standard deviation is still a simple measure of, 'how much returns can fluctuate'.

Investors should determine the standard deviation of the instrument that they have in mind. Knowledge of this will prevent them from making wrong choices.

For example, the standard deviation of an equity fund over the last 5Y period is 20% and the standard deviation is 12%. This means, the error in the average is comparable to the average. Meaning, that if we invest in equity for short durations, it is a gamble. The result can turn out to be anything.

If I want to invest for say, 5 years, and wish to choose a particular instrument which is volatile, I must have an idea how much the returns of the instrument can fluctuate over 5 years.

For this, I need to know the 5Y rolling return data - which can be obtained with this Excel sheet and

I need the rolling standard deviation data - which can be obtained with this Excel sheet.

This then gives mean an idea of how much returns can fluctuate and whether it is worth the risk.

However, doing this can be pain. I don't want to do this, I dont have much choice to expect what is available.

I can only find standard deviation listed for all funds in tabular form at VR online. I am assuming that this is for the last 3Y period (on trailing basis) - VR does not say and does not bother to respond.

Morning Star clearly mentions duration over which standard deviation is computed  but does not provide it in tabular format.

So we will have to make do with the VR data which we shall assume is for 3 years.

Here is a chart of the minimum and maximum standard deviations found for each of the equity mutual fund categories at VR.

This forms a sort of risk ladder which one can use to understand how much funds in each categories can fluctuate and how much there is overlap in volatility.

Equity-mutual-fund-risk-ladder

  • Gold is highlighted to point out that it is as risky as equity but returns like debt before tax
  • The red vertical lines are guides referenced to large caps.
  • Notice that much of the risk associated with equity-oriented balanced funds overlaps with equity funds. I wish people stop recommending them to those new to equity investing. It will not help much, unless some makes a conscious choice to pick the one with lowest standard deviation, unmindful of returns.
  • Pharma and FMCG sectors are as volatile as large-caps. Can someone educate me why?
  • The other sectors are more volatile. Banking is nuts!
  • I should have marked the category averages there, but was too lazy.
  • International equity is all over the place because of current fluctuations. Read more: Portfolio diversification with international stocks
  • Notice ELSS volatility is pretty much similar to that of large caps
  • Notice the additional risk that mid and small-cap funds take over large caps. The additional risk could result in higher returns but at much higher investor stress.
  • Equity multi-cap and large/mid-cap fund categories spread out on either side of the large caps. For some funds, the lower standard deviation could be because of diversification and poor correlation among the portfolio stocks. Holding one fund in such a category is enough  to represent an equity folio. Of course, one will have to be careful about the fund strategy and check other parameters like downside protection.

Will try and post a similar chart for debt funds and see if I can combine all fund categories together.

One can also plot the min and max return along with min and max standard deviation. However, we would be dealing only with data over 3 years. Which is not representative. If only I could get such data for last 10 years!

Although I do not expect the above risk ladder to change much, long-returns would be more reliable.

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45 thoughts on “Risk Ladder for Equity Mutual Funds: Watch your step!

  1. Raghu Ramamurthy

    The adverse effects from high standad deviation investments can to some extent be avioded through SIP.But you are against SIP mode of investment.You seem to be against investments in products having high standard deviation.Do you mean to say an individual with a low risk profile should totally keep away in equity investment.The only alternative is a bank FD.This is also a no brianer considering the tax angle and leaping inflation.Am confused.Where do you want such an individual to park his savings?

    Reply
  2. Raghu Ramamurthy

    The adverse effects from high standad deviation investments can to some extent be avioded through SIP.But you are against SIP mode of investment.You seem to be against investments in products having high standard deviation.Do you mean to say an individual with a low risk profile should totally keep away in equity investment.The only alternative is a bank FD.This is also a no brianer considering the tax angle and leaping inflation.Am confused.Where do you want such an individual to park his savings?

    Reply
  3. R.Masilamani

    Dear Ramamurthy sir,
    While explaining normal distribution bell curve ,Mr.Pattu has referenced a source which explains the relationship between volatility and compounding.If I remember the name of the author is David Vardi. You will get answer for low risk profile vs high risk profile.

    Reply
  4. R.Masilamani

    Dear Ramamurthy sir,
    While explaining normal distribution bell curve ,Mr.Pattu has referenced a source which explains the relationship between volatility and compounding.If I remember the name of the author is David Vardi. You will get answer for low risk profile vs high risk profile.

    Reply
  5. Deepomouli Ghosh

    Thats why equity investment should not be done for short term.However in the long term equity returns follows the underlying business returns.In the short run market movements depict price discovery by various market participants,however over a period of 15 - 20 years returns are invariably aligned to the actual returns made by underlying business.As people begin to understand the volatile nature of equity markets,they would be more comfortable with it so as to focus on long term.

    Reply
  6. Deepomouli Ghosh

    Thats why equity investment should not be done for short term.However in the long term equity returns follows the underlying business returns.In the short run market movements depict price discovery by various market participants,however over a period of 15 - 20 years returns are invariably aligned to the actual returns made by underlying business.As people begin to understand the volatile nature of equity markets,they would be more comfortable with it so as to focus on long term.

    Reply
  7. GM

    Hi,

    Regarding Pharma & FMCG volatility, the explanation could be quite simple. Assuming you're using nifty indices for your data, then 75% of the pharma and FMCG index is represented within the nifty. And CNX FMCG has a 59% (!) weight to ITC! Their weights in the index are between 6-8%.

    Further - and it would be interesting to see this - I'd be willing to guess that correlations within nifty stocks are fairly high. Of course, it would be great to have this data validated! Maybe FII flows are mostly in Nifty and those monies are mostly consistent.. or maybe something else entirely.

    The other possibility is that - given the operating nature of these businesses - the defensiveness, pricing power, etc. probably are similar with much of the underlying businesses in the Nifty as well that fall outside the 2 sectors and are supposed to be cyclical - HDFC, ICICI, L&T etc. - but due to their sheer size and brand are almost semi-defensive.

    Personally, I'd be VERY interested in seeing Sharpe or Sortino ratios category wise as you've done. At this point its probably been very nice for large cap fund managers to drift towards midcap fare - which is why I love having these riskier funds along with QLTE!

    Reply
  8. GM

    Hi,

    Regarding Pharma & FMCG volatility, the explanation could be quite simple. Assuming you're using nifty indices for your data, then 75% of the pharma and FMCG index is represented within the nifty. And CNX FMCG has a 59% (!) weight to ITC! Their weights in the index are between 6-8%.

    Further - and it would be interesting to see this - I'd be willing to guess that correlations within nifty stocks are fairly high. Of course, it would be great to have this data validated! Maybe FII flows are mostly in Nifty and those monies are mostly consistent.. or maybe something else entirely.

    The other possibility is that - given the operating nature of these businesses - the defensiveness, pricing power, etc. probably are similar with much of the underlying businesses in the Nifty as well that fall outside the 2 sectors and are supposed to be cyclical - HDFC, ICICI, L&T etc. - but due to their sheer size and brand are almost semi-defensive.

    Personally, I'd be VERY interested in seeing Sharpe or Sortino ratios category wise as you've done. At this point its probably been very nice for large cap fund managers to drift towards midcap fare - which is why I love having these riskier funds along with QLTE!

    Reply
  9. gaurang

    Dear Sir how can i asset allocate in Mf for long term . Goal 1 Child Education , 2 Child Marriage,3 Retirement , Amt allocate 10k for 15 yr

    Reply
  10. gaurang

    Dear Sir how can i asset allocate in Mf for long term . Goal 1 Child Education , 2 Child Marriage,3 Retirement , Amt allocate 10k for 15 yr

    Reply
  11. Pattabiraman Murari

    No sir. A SIP only averages entry points. I does not help assuage adverse effects of standard deviation. It is a conterintuitive concept. Low standard deviation does not guarantee low risk! I find that some min risk is necessary. Will work on this more and post.

    Reply
  12. Pattabiraman Murari

    No sir. A SIP only averages entry points. I does not help assuage adverse effects of standard deviation. It is a conterintuitive concept. Low standard deviation does not guarantee low risk! I find that some min risk is necessary. Will work on this more and post.

    Reply
  13. Rahul

    I have a few questions related to mutual funds:
    1) Is there a way to find out PE ratio or PEG ration of a MF? If yes, where? or is there any tool that you have developed?
    2) Where can I check standard deviation in MF? Preferably year or year std dev.
    3) What is a high beta and a low beta fund? Where can i find this information of a MF? Any tool?

    Reply
    1. freefincal

      You get all this information at Morning Star. I dont see much use for 1.
      You will not get year by year std dev. I have a tool for this, but it is not necessary/
      High beat fund is relatively more volatile than its benchmark.

      Reply
      1. Rahul

        Hi,
        For points#1 and 2 you mentioned that it is not so useful. You mean standard deviation and PE / PEG ratios for MF are no important metrics to evaluate?

        Reply
        1. Rahul

          Hi,
          I am facing 2 issues on your site since yesterday.
          i) I am not able to see any pictures on any articles.
          ii) I am not able to download any calculators.

          For both i get this message:
          "THIS IS SOMEWHAT EMBARRASSING, ISN’T IT?
          It seems we can’t find what you’re looking for. Perhaps searching can help."

          Are others facing the same issue? Some issue with your site?

          Regards,
          Rahul

          Reply
          1. freefincal

            Yes, I am aware of this. Will take me a few days to fix this. In the meantime, let me know what files you need and I will;l upload that first.

          1. Rahul

            Thanks for the calculator link. Wish you and your team a very happy, healthy and prosperous new year.

  14. AVM

    Dear Pattu Sir, based on a very quick study, it appears that the std. dev. quoted by both Morningstar and VRO is the std. dev. of the monthly return for the trailing 36 months.
    The three year values are the same on both the sites for a particular fund, and since we know Morningstar methodology is using monthly returns, it looks like VRO is also the same.
    This to me is a misleading measure, as I am least bothered about monthly return for an equity fund! I would be more interested in the standard deviation of the 3 year rolling returns, and 5 year, 10 year, 15 year and 20 year! Unfortunately, this has to be manually calculated, from NAV historical values.

    Reply
    1. freefincal

      Yes, I am aware of this. It is not the std dev of 3 year returns (this is not practical), but the std dev of month returns over 3Y. I have a rolling std dev calculator. You could try that.

      Reply
      1. AVM

        Will check out this calculator as well, but right now, the link to the calculator is broken.

        Will check again when you have the site back to normal.

        Reply

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