Module 2 : Equity Funds
How to invest in equity – Tenure and Risk Profile
There are several categories of equity mutual fund schemes e.g. large cap, midcap, small cap, large & midcap, multi-cap, flexi-cap, etc. As different fund categories have different risk characteristics, the question is how to invest in equity mutual funds. You should invest in the appropriate category of funds based on two most important factors - investment needs and risk profile.
How to invest in equity – Tenure and Risk Profile
There are several categories of equity mutual fund schemes e.g. large cap, midcap, small cap, large & midcap, multi-cap, flexi-cap, etc. As different fund categories have different risk characteristics, the question is how to invest in equity mutual funds. You should invest in the appropriate category of funds based on two most important factors - investment needs and risk profile.
Investment tenure
Tenure is the time period for which you plan to remain invested in a fund. It is one of the most important investment considerations because tenure has a direct bearing on risks and returns. Being disciplined in your investment plan is essential for successful investments – if you redeem your funds before the recommended tenure you may get much lower returns than expected. Before investing, you should decide how long you intend to remain invested and then remain committed to your tenure despite ups and downs in the market.
Financial advisors suggest that mutual fund investments should always be tied to your financial goals. All investors have different life-stage goals e.g. buying a house, children’s education, children’s marriage, retirement planning etc. For example, if you are investing for your child’s higher education and he / she is 5 years, then investment tenure will be 13 years, assuming your child begins college education at the age of 18. Similarly, if you are 30 years old and you are investing for your retirement, then your investment tenure will be 30 years, assuming you retire at 60.
Equity as an asset class is volatile in the short term (see the parts of Nifty 50 TRI chart circled in red). Equity is not suitable for short investment tenures. However, if you have long investment tenures, then you can give your investments sufficient time to recover from deep corrections and get good returns over the tenure of the investment.
Source: National Stock Exchange, Advisorkhoj Research. Period: 01-01-2001 to 31.12.2020. Disclaimer: Past performance may or may not be sustained in the future
Longer your investment tenure, higher is your risk capacity. If you have longer tenures then you can invest in more volatile fund categories which may have the potential of giving higher returns over sufficiently long investment tenures. For example, midcap and small cap funds are more volatile than large cap funds but have the potential of giving higher returns than large cap funds over long investment tenures. If you are investing in midcap and small cap funds, then you should have longer investment tenures compared to large cap investors.
Risk Appetite
What is risk profile meaning? Your risk profile is another important factor in equity investments. Equity, as an asset class, is not suitable for investors with low risk appetite – you need to have sufficiently high risk appetite to invest in equities. Risk appetite of an investor is based on both objective and subjective factors. Among the objective factors which determine risk appetite the two most important factors are age and investment horizons. Young investors have higher risk appetite than older investors. Investors with longer investment horizons also should have higher risk appetite than those with shorter investment horizons. Risk appetite of investors is also based on subjective factors like a person’s temperament, attitude towards risk, investment experience etc. A person with a nervous disposition is likely to have lower risk appetite. A person with more investment experience is likely to have higher risk appetite than a new / less experienced investor.
Risk profiling
Different equity fund categories also have different risk profiles e.g. large cap funds have lower risk profiles than mid and small cap funds. Funds which invest across market cap segments e.g. large and midcap funds, multi-cap funds, flexi-cap funds etc. have risk profiles which are intermediate between large cap and mid / small caps. Association of Mutual Funds in India (AMFI) has developed a Riskometer for the purpose of risk profiling different mutual fund schemes, so that mutual fund investors can make informed investment decisions according to their risk appetites. There are six types of risk profiles as per AMFI’s Riskometer.
⦁ Low: If your top priority is safety of your capital then you should invest in funds with low Riskometer profile.
⦁ Moderately low: If you are willing to take a small amount of risk in order to get higher returns in medium to long term then you can invest in funds with moderately low Riskometer profiles.
⦁ Moderate: If you are willing to take a moderate risk in order to get higher returns in medium to long term then you can invest in funds with moderate Riskometer profiles.
⦁ Moderately high: If you are willing to take a relatively higher risks in order to get maximize returns in the long term then you can invest in funds with moderately high Riskometer profiles.
⦁ High: If you are willing to take high risks in order to get high returns in the long term then you can invest in funds with high Riskometer profiles. While returns can be high for these funds, you should also be prepared for high volatility.
⦁ Very High: This is the highest risk grade. While you can get potential superior returns, the risk of capital loss is also highest in this Riskometer profile.
Mutual fund distributors or financial advisors are required to carry out risk profiling or risk profile management of their investors before recommending suitable funds to them. Some advisors may determine your risk profile based on discussions with you, while others may ask you to fill out a risk questionnaire to determine your risk profile. Fund houses are required to label all their schemes with the appropriate Riskometer grade so that you can match your investments with your risk appetite. For equity funds, you need to have moderately high to high risk appetites. For certain categories of equity funds e.g. small cap funds, sector funds etc you should have high risk appetites.
Conclusion
Investors should understand their risk appetite and consult with a financial advisor if required. You should also plan the tenure of your investment and remain disciplined irrespective of market volatility.
Investment tenure
Tenure is the time period for which you plan to remain invested in a fund. It is one of the most important investment considerations because tenure has a direct bearing on risks and returns. Being disciplined in your investment plan is essential for successful investments – if you redeem your funds before the recommended tenure you may get much lower returns than expected. Before investing, you should decide how long you intend to remain invested and then remain committed to your tenure despite ups and downs in the market.
Financial advisors suggest that mutual fund investments should always be tied to your financial goals. All investors have different life-stage goals e.g. buying a house, children’s education, children’s marriage, retirement planning etc. For example, if you are investing for your child’s higher education and he / she is 5 years, then investment tenure will be 13 years, assuming your child begins college education at the age of 18. Similarly, if you are 30 years old and you are investing for your retirement, then your investment tenure will be 30 years, assuming you retire at 60.
Equity as an asset class is volatile in the short term (see the parts of Nifty 50 TRI chart circled in red). Equity is not suitable for short investment tenures. However, if you have long investment tenures, then you can give your investments sufficient time to recover from deep corrections and get good returns over the tenure of the investment.
Source: National Stock Exchange, Advisorkhoj Research. Period: 01-01-2001 to 31.12.2020. Disclaimer: Past performance may or may not be sustained in the future
Longer your investment tenure, higher is your risk capacity. If you have longer tenures then you can invest in more volatile fund categories which may have the potential of giving higher returns over sufficiently long investment tenures. For example, midcap and small cap funds are more volatile than large cap funds but have the potential of giving higher returns than large cap funds over long investment tenures. If you are investing in midcap and small cap funds, then you should have longer investment tenures compared to large cap investors.
Risk Appetite
What is risk profile meaning? Your risk profile is another important factor in equity investments. Equity, as an asset class, is not suitable for investors with low risk appetite – you need to have sufficiently high risk appetite to invest in equities. Risk appetite of an investor is based on both objective and subjective factors. Among the objective factors which determine risk appetite the two most important factors are age and investment horizons. Young investors have higher risk appetite than older investors. Investors with longer investment horizons also should have higher risk appetite than those with shorter investment horizons. Risk appetite of investors is also based on subjective factors like a person’s temperament, attitude towards risk, investment experience etc. A person with a nervous disposition is likely to have lower risk appetite. A person with more investment experience is likely to have higher risk appetite than a new / less experienced investor.
Risk profiling
Different equity fund categories also have different risk profiles e.g. large cap funds have lower risk profiles than mid and small cap funds. Funds which invest across market cap segments e.g. large and midcap funds, multi-cap funds, flexi-cap funds etc. have risk profiles which are intermediate between large cap and mid / small caps. Association of Mutual Funds in India (AMFI) has developed a Riskometer for the purpose of risk profiling different mutual fund schemes, so that mutual fund investors can make informed investment decisions according to their risk appetites. There are six types of risk profiles as per AMFI’s Riskometer.
⦁ Low: If your top priority is safety of your capital then you should invest in funds with low Riskometer profile.
⦁ Moderately low: If you are willing to take a small amount of risk in order to get higher returns in medium to long term then you can invest in funds with moderately low Riskometer profiles.
⦁ Moderate: If you are willing to take a moderate risk in order to get higher returns in medium to long term then you can invest in funds with moderate Riskometer profiles.
⦁ Moderately high: If you are willing to take a relatively higher risks in order to get maximize returns in the long term then you can invest in funds with moderately high Riskometer profiles.
⦁ High: If you are willing to take high risks in order to get high returns in the long term then you can invest in funds with high Riskometer profiles. While returns can be high for these funds, you should also be prepared for high volatility.
⦁ Very High: This is the highest risk grade. While you can get potential superior returns, the risk of capital loss is also highest in this Riskometer profile.
Mutual fund distributors or financial advisors are required to carry out risk profiling or risk profile management of their investors before recommending suitable funds to them. Some advisors may determine your risk profile based on discussions with you, while others may ask you to fill out a risk questionnaire to determine your risk profile. Fund houses are required to label all their schemes with the appropriate Riskometer grade so that you can match your investments with your risk appetite. For equity funds, you need to have moderately high to high risk appetites. For certain categories of equity funds e.g. small cap funds, sector funds etc you should have high risk appetites.
Conclusion
Investors should understand their risk appetite and consult with a financial advisor if required. You should also plan the tenure of your investment and remain disciplined irrespective of market volatility.