How to Measure Risks in Mutual Funds?
Before you jump start your monthly-SIP or lump-sum equity plan, let’s get this clear that these investments are subject to market risk. Now when this statement pops up or scrolls by on the big fat TV Screen, what do you think it means? To put it in layman’s term ‘You cannot expect a fixed return on your fund invested.’ There’s always a risk of market volatility gawking on your funds.
Fret not; you can always research better to invest better and make sound investment decisions when it comes to mutual funds. Let’s quickly come to risk measuring.
Yes, it’s possible and within your means to delve into the true basics of indicators; alpha, beta, and r-squared that tells you what risk is associated with your fund portfolio. Other statistical measures such as calculation of standard deviation and shape ratios are important to calculate or estimate the risk.
Sure, all backs up the estimation values as when it comes to the volatility of the market, no one can put a word to it. Market volatility is altogether a sensitive scenario which depends upon several factors including politics. Let’s know learn how can we calculate/measure risks!
Modern Portfolio Theory:
Or should we say a bible for expert investors? Although there are various “SIP-Calculators” and other calculators that track “Mutual Fund’s Growth and Return” but without considering the omnipresent risk factor, one cannot take his pick. Let’s tell you why!
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MPT or Modern Portfolio Theory is a theory defined as:
For a given market risk level, the maximization of investment return is supported by the theory of Modern Portfolio.
The objective of these portfolios is to maximize the return (profit) on a fund investment while considering (and hence minimizing) the level of market risk.
As mentioned, the market is not static, it is ever changing. Therefore, to make an estimation of how the market will deviate and how will it affect your own fund. For a desirable return, it’s possible for an investor to construct a portfolio such that he/she could minimize the whole lot of risks.
The question is, how? The answer lies in the introductory part of this piece. There are a handful of indicators and other statistical measures that help us calculate the risk involved. Once we track down the possible risks (in numbers – thanks to the statistical measures), we can find ways to minimize those risks.
One thing to keep in mind is that return of your portfolio is calculated as the weighted sum of the return of the individual assets in your portfolio.
For example, (6% x 25%) + (4% x 25%) + (14% x 25%) + (10% x 25%) = 8.5%
The portfolio is divided into four parts (assets) for which the return is expected as 6%, 4%, 12%, and 10% respectively. The total becomes 8.5% and the risk associated with the assets giving 4% & 6% return is mitigated or balanced.
How to Measure Risks in Mutual Funds?
Risk-adjusted calculation on a fund can be done using the alpha measure.Alpha uses a benchmark index which is the center of calculation for this indicator.
Basically, alpha takes the risk-adjusted return (performance) of a fund investment and compares it with the benchmark index. This comparison yields out the possible value for alpha which specifies the performance or underperformance for a fund.
Alpha is commonly a measure that specifies the security of a fund as per the benchmark index. Let’s say, after the calculation, the value of alpha is 1.0. It means that the fund has outperformed as compared to the benchmark index by 1%.
On the other hand, if the value of alpha is -1.0 – it means that the portfolio fund has underperformed as per its benchmark index (mostly due to the volatility of the market).
The next indicator to measure the risk associated with a mutual fund is beta. Beta talks general i.e. it takes the whole market into consideration and analyzes the systematic risk associated with a specific fund portfolio. Just like alpha, the values of beta or “beta coefficient” also tell us a “market-compared” result.
However, the value of Beta can be calculated using advanced statistical analysis technique known as “Regression Analysis”. Beta is affected by the movements in the market. By the standards, the market has a value of 1%.
If the value of beta comes out to be less than 1, the volatility of the fund will be lesser than that of the market. Similarly, if the value of Beta is captured to be more than, say 1.1% then the volatility of the fund is 10% more as compared to the volatility of the market.
What’s favorable for the fund with least risk associated? – Low beta.
The calculation of Standard Deviation has a plethora of applications around the globe in various sectors. And luckily, one in the sector of Finance. Standard Deviation graphically shows how scattered a particular distribution is. In plain and simple words, SD or Standard Deviation makes use of the historical data to put an analysis over the current funds.
Generally, an SD-graph would tell how deviated is your “annual rate of return” from what it is expected from the historical sources. Using this calculation, the future predictions can be made most naturally.
A volatile stock has a higher Standard Deviation.
Mean is a measure of central tendency which holds an importance while calculating the values of Standard Deviation. SD tells how much dispersion of data is there from its mean. Various expert investors make use of this indicator to minimize the risk factors in a portfolio.
Also read: Where Should You Invest Your Money?
As we have seen, there are various possible ways through which one can estimate the risks in mutual funds.
A portfolio consisting of different assets would have different risk factors associated individually. Therefore, to make the best decision and to minimize the individual risks in your portfolio, the indicators mentioned above can lend you a helping hand.
For a finance newbie, these things might be no less than a rocket science right now. However, eventually one can get a hang of it. After all, a good investment is most naturally important for a good return.