Will I get more returns if I take more risk? Higher risk = higher returns?

Published: March 5, 2018 at 2:36 pm

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Many investors are under the impression that to get higher returns, one must take on more risk. This is reasonably true if the investment duration is “long enough” and completely wrong for shorter durations. In a two-part post, I consider the risk and return associated with all mutual fund categories. This is an updated version of what I had previously discussed: The key to successful mutual fund investing

In this post, let me take the easy way out and consider a duration of 3 years. The easy way out because the data is readily available at Value Research. Many investors, especially first time ELSS fund investors believe 3 years is “long enough” to get “good returns” from equity. Well, let us find out. In the second part, I shall consider 5Y and 10Y – for this, I need to crunch the numbers myself.

First some basics:

Investment risk

Risk is defined by the standard deviation. That is, the monthly returns of a fund over the last 3Y is calculated. Then we find out the average monthly return and how much each return deviates from the average.

This measure of “deviation from average” is known as standard deviation. It is a standard, but a simplistic measure of risk (and therefore convenient).

Investment Return

This is simply the last 3Y annualized return or the CAGR

Mutual Fund Categories

These are the present Value Research fund categories. They are set to change due to the SEBI classification, but no harm is looking at what is available now.

CategoryFull Form
EQ-INTLInternational Equity funds
EQ-LCEquity large-cap funds
EQ-OTHEquity “others”
EQ-MLCEquity Multicap
EQ-MCEquity Midcap
EQ-TSEquity ELSS
EQ-ITEquity Infotech
EQ-CGEquity Consumer goods
EQ-SCEquity Small cap
EQ-PHEquity Pharma
EQ-INFRAEquity Infrastructure
EQ-BANKEquity Banking
DT-LIQLiquid funds
DT-FMPFixed maturity plans
DT-USTUltra short-term
GL-STGilt short term
DT-STShort-term debt funds
DT-COCredit opportunity debt funds
DT-INCDebt income funds
DT-DBDynamic bond funds
GL-MLTMedium and long-term gilt
HY-ARHybrid arbitrage
HY-DChybrid debt oriented conservative
HY-OTHHybrid others
HY-DAHybrid debt oriented aggressive
HY-EQHybrid equity oriented
HY-AAHybrid asset allocation

Mutual Fund Risk ladder

So how do fluctuations in monthly returns increase across categories?

Right from liquid funds (lowest risk) on the extreme left, notice how risk increases in step-wise manner as you head to equity small caps on right (see the sudden spike in risk there). Please spend some time in locating each fund category in this ladder.

Mutual Fund Risk vs Return (3 years)

To plot this, let us first rotate the above graph.

rotated mutual fund risk vs categories

mutual fund risk vs return over 3 years

The 3Y return (Y-axis) is plotted vs the 3Y risk. The horizontal axis for both the graphs are the same to enable comparison.

As you go from liquid funds to small-cap funds, notice how the spread in returns increases. There are some extreme points in the bottom right of the graph – these are international funds (eg. world gold mining fund)

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Readers may be aware of an “infographic” published earlier: Assorted infographics on personal finance

infographic-personal-finance-3

Can you see the similarity?

As the investment risk (or standard deviation) increases, the range of returns possible increases.

What does this mean?

When risk increases, risk increases!! The return may or may not increase.  This is over 3Y. I am curious to see how this changes over 10Y.

Risk per unit return vs risk for all categories

Now we divide the risk by the return and plot it against risk.

Please take a while to spot your favourite mutual fund category in the plot. Notice that as risk increases, the risk per unit return also increases and at the highest levels of risk, the linear trend weakens.

Some data points deviate below the linear trend. Meaning higher returns and higher risk (lower risk/return)

Some data points deviate from the linear trend. Meaning lower returns and higher risk (higher risk/return)

So, Will I get more returns if I take more risk? Over 3 years, the answer is, maybe yes. Maybe no, but I will definitely get higher risk, if I take higher risk. duh!

 

 

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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

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