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:
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).
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.
|EQ-INTL||International Equity funds|
|EQ-LC||Equity large-cap funds|
|EQ-CG||Equity Consumer goods|
|EQ-SC||Equity Small cap|
|DT-FMP||Fixed maturity plans|
|GL-ST||Gilt short term|
|DT-ST||Short-term debt funds|
|DT-CO||Credit opportunity debt funds|
|DT-INC||Debt income funds|
|DT-DB||Dynamic bond funds|
|GL-MLT||Medium and long-term gilt|
|HY-DC||hybrid debt oriented conservative|
|HY-DA||Hybrid debt oriented aggressive|
|HY-EQ||Hybrid equity oriented|
|HY-AA||Hybrid 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.
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)
Readers may be aware of an “infographic” published earlier: Assorted infographics on personal finance
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!