When mutual fund advertisement say “Mutual Fund Investments are subject to Market Risk”, please take these words seriously. First step in managing the risk associated with investing is to understand what the risk is. So what is Market Risk? We can say that Market Risk is the possibility of loss caused by changes in the market variables. Market Risk is therefore the risk to the investor’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. As an investor, you know it that risk and returns are interlinked. Higher the possibility of risk, higher is the return you expect from the investment. Market risk is such a risk which cannot be avoided. You can greatly benefit from the existence of market risk.
Asset Diversification – This means owning different types of assets. All assets do not perform the same way at any given point of time. If you own a diversified portfolio of assets, you possibly do not lose the same amount when you own a single asset portfolio. Example: You can have a portfolio consisting of diversified equity fund, long term income fund, gold fund and an infrastructure fund. How much to invest in each fund is dependent on your risk tolerance.
Time Diversification – Assets behave differently when time dimension is taken in to account. A good example is the way debt and equity investments behave across time. Equities tend to outperform other assets classes over a time. If you are long term investor, investing in debt may actually reduce your wealth due to the burden of tax and inflation. Example: When you are planning for your retirement which is 35 years ahead (this period we call as accumulation/growth phase) is the best time to invest in riskier assets such as equities. When you are in transition phase, you must move to more stable and less risky assets.
Rupee Cost Averaging – Another popular technique to reduce market risk is by investing a similar amount regularly. Over a period of time, because of the underlying price volatility of the assets you are investing in, your cost of acquisition is averaged. Example: The popular method of investing in mutual funds called “Systematic Investment Plan” and less used option “Systematic Transfer Plan” are the best examples of Rupee Cost Averaging.
Rupee Value Averaging – in periods of market declines, you contributes more, while in periods of market climbs, you contributes less. Example: Some mutual funds have the options under “Systematic Transfer Plan” to increase the amount invested when the bench mark index falls in value. You can also invest lump sum amount when value of the asset falls. What strategy would work for you better is dependent on your individual circumstances. When you talk to you financial planner, you will know the best possible options.
