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June 3, 2023

How to measure risks in mutual funds

Mutual funds, like any other form of investment, carry their advantages and disadvantages. Hence, there are multiple risks that a mutual fund investment can encounter if not measured wisely. Some of the types of risks associated are as follows:

  1. Market risk
  • This is the risk related to the one-liner disclaimer in advertisements you might have noticed – mutual funds are subject to market risks. Read all scheme related documents carefully.
  • A market risk is a type that carries the potential risk an investor may face if the market performance turns out to be poor.
  • A few of the common parameters that affect the overall market performance are as follows – recession, inflation, political unrest, natural calamities, constantly fluctuating rate of interest, etc.
  • Market risk is generally called systematic risk. It is not in the hands of the investor to control any of these parameters.
  1. 2. Concentration risk
  • Many times, investors fail to diversify their investments and end up concentrating a handsome investment amount in one dedicated scheme.
  • In favourable scenarios, the profit numbers will multiply tenfold, but if things do not work in favour, the losses can be beyond your control.
  • The only principle to lower this type of risk is portfolio diversification. The more diverse the portfolio, the better the risk is hedged.
  1. 3. Interest rate risk
  • Interest rate fluctuations depend on credit outstanding with the lenders and subsequent demand raised by the borrowers.
  • These factors are in an inverse relationship with each other.
  • If there is a reduction in the price of the securities, it states that there is an increase in the rate of interest. Risk and returns in mutual funds are also inversely proportional to each other.

Let us now have a look at how to measure the risk associated with a mutual fund. These indicators help to get deeper insights into the risk and return profile of mutual funds as they provide information pertaining to the volatility and investment risk – thereby covering components of modern portfolio theory.

  1. Alpha
  • It is a technique used to measure the performance of an investment in relation to a benchmark index.
  • The first step is considering the volatility (in consideration is – price risk) of a security or fund portfolio, further comparing that risk-adjusted performance to a benchmark index.
  • Any excessive return observed of investment relative to the benchmark return is called its alpha.
  • Generally, an alpha of 1.0 represents the outperformance of a fund to its benchmark index by 1%.
  • Similarly, an alpha of -1.0 would equal an underperformance of 1%. For investment purposes, the higher the alpha, the better.
  1. Beta
  • Beta is computed with the help of the regression analysis technique, as it is an indicator of an investment’s return vis-à-vis the market movement.
  • It compares the investment’s performance, particularly its volatility in terms of price fluctuations, to the market as a whole.
  1. Standard deviation
  • Standard deviation is applied to have clarity on volatility. Higher the standard deviation, the higher the volatility of the stock.
  • In the case of mutual funds, a standard deviation helps analyse the deviation of returns on the fund as expected based on historical performance.

As we observe several ways of ‘how to measure mutual fund risk’, it is crucial to apply them in time to find some balance in the risk and return aspects of mutual funds. You can also consult a financial advisor who can guide you on the kind of mutual fund investments that are best suited for you.

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