Understanding Mutual Fund Investment Risk vs Reward

Published: April 22, 2016 at 10:22 am

Although it has limited technical utility, the standard deviation is probably the simplest measure of understanding investment risk. Therefore, it has great practical value when it comes to ‘product positioning’ as the fund industry calls it.

‘Where does a given fund fall in the risk vs reward map?’. AMC often given a product positioning risk vs reward ‘map’ in their presentations. This is for HDFC Equity Savings fund.

standard-deviation-3 Source: HDFC Product presentation

They have now ‘positioned’ their equity savings funds bang in the middle. Just below balanced funds and just above debt funds.

Such illustrations give the incorrect impression that higher the risk, higher the reward. The reality is,

higher the risk, higher the potential for reward and equally higher the potential for loss.

The simplest way to represent this is the standard deviation.

standard-deviation-1

The 3-year return for a few equity funds are shown above. The black dots represent the actual value of the return. The vertical line segments on each black dot represents the standard deviation. Higher the standard deviation, higher the length.

Technically, the length of the line represents the spread in monthly returns about the average monthly return. However, it is an excellent measure of what the return would be after a 3-year investment period.

Now let us represent all equity and debt funds in the same way.

standard-deviation-2

Notice that the return spreads are very small to the left. These are for short-term debt mutual funds. Gradually the spread becomes bigger and bigger.

One the right extreme are equity sector mutual funds. Just below them diversified mutual funds. Right in the middle are the hybrid funds. Equity savings funds would be found somewhere close to the red arrow.

This is the reality – higher the risk taken, higher the spread in returns. I love to depict this as,

infographic-personal-finance-3

Maybe this should be freefincal’s cover picture!

Understanding risk is the key to successful mutual fund investing

A plot published earlier. The y-axis is 3-year return divided by the 3-year standard deviation.

ret-std-2

Can you guess where equity savings funds would be positioned?

Read more:

How to select mutual fund categories suitable for your financial goals?

How to Select Debt Mutual Funds Suitable For Your Financial Goals?

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps