One of the most popular beliefs in the investing circles is that if you want to generate high returns on your investment, then you need to take high risks. While this might be true in some cases, it is not entirely true for all people.
The reason is simple – every person has a different definition of risks. Another major concern is putting a number to the risk associated with an investment. While there are numerous financial ratios and experts offering guidance on calculating investment risks, the core aspect considered by most analysts is the volatility in the price of the asset.
Let’s break this down.
How do 'high risk = high returns' work?
If you are investing in a share, then its price changes every minute. Hence, when you are looking for a low-risk investment, you will try to find stocks that don’t have highly volatile prices. But, the problem with such stocks is that since they don’t move much, the returns are fairly low.
On the other hand, if you look at the stock of a small-cap company, then you will find that the percentage increase or decrease in its price is very high. Hence, it offers an opportunity to earn high returns.
Let's understand with an example
Let’s say you decide to buy stocks of ABC ltd that have high debts. Such companies are known to be high-risk companies for investors.
If high risks equal high returns, then investing in such companies should offer higher returns.
However, if you look at the performance of companies in the past, then you will observe that low-debt companies tend to offer better returns than those with higher debts, in the long run.
The high-risk = high returns equation doesn't play out.
How low-risk mutual funds can offer high returns
Many investors have a simple view of the risk-reward relationship. They believe that if they want to earn a higher return, then they will have to invest in medium-to-high-risk equity mutual funds.
If you look at the example cited above, then one can extrapolate that even in mutual funds, high risk will not always imply high returns.
In fact, you will be surprised to know that some of the low-risk funds offer better returns than their high-risk counterparts.
- When a mutual fund creates a low-risk portfolio, the goal of the fund manager is usually capital preservation. Therefore, she/he chooses assets that are not highly volatile and have strong fundamentals. These can be stocks or debt instruments or any other assets. Hence, these portfolios safeguard your investment from market volatility. This ensures that you get steadier returns than the more volatile investments. Also, over the long term, you can generate better returns.
- Low-risk mutual funds tend to invest in high-rated and/or low-volatility securities. Hence, the risk is near-zero while the returns are relatively steadier. Since markets are inherently volatile, these funds can offer better returns over time.
- A low-risk debt fund offers the indexation benefit that makes it a tax-efficient investment option. Depending on your tax bracket, this can help you save tax and boost your returns.
- Index funds are usually considered to be low-risk funds and allow you to benefit from the overall growth of the market. In the long run, these funds can offer high returns without exposing you to the risks of the drop in performance of certain sectors or industries. Also, since these are passively managed funds, there is no risk of an erroneous decision of the fund manager.
Check out Best Low-Risk Mutual Funds to Invest in 2022
Factors for maximum returns with minimum risk in MFs
So, what is the trick? How can you ensure maximum returns with minimum risks? While there is no ‘master key’ to this, here are a few pointers that can help you reduce the overall risk of your mutual fund portfolio:
- Understand your risk tolerance – Remember, every investor has a distinct level of tolerance to investment risks. This can also vary at different stages of your life. Hence, the first thing you must consider is the level of risk you are willing to take. Think about your financial goals and commitments and make sure that you draw the line carefully.
- Research the market – There are hundreds of mutual fund schemes to choose from. While your family and friends might recommend certain schemes, it is prudent to research the mutual fund market before making a choice. Every fund manager tries to offer the best returns to investors while exposing the portfolio to minimise risks. What you need to look for are schemes that suit your risk appetite.
- Calculate the risk yourself – Mutual funds schemes declare the investment risk on the scheme documents. Before choosing a fund based on the riskometer, go through the portfolio and the asset allocation strategy of the fund. This will help you assess if the risks are within your tolerance limits or not. Also, read up about the fund manager and look at the history of the different funds he/she has managed.
- Don’t forget taxation – Tax can eat up into your returns if not planned properly. Hence, while calculating returns, always keep the tax rules in mind.
The traditional approach of drawing a direct correlation between risks and rewards might not work in all situations.
Hence, modern investors need to start looking at risks differently. Making an informed decision can help you generate high returns even from low-risk mutual funds.
It is better to avoid the urge to blindly follow the equation of high risks=high returns and make informed investment decisions.