Mitigate risk in mutual funds through diversification

One of the risk mitigation strategies of investing in equities is to diversify and average the cost. Arguably, there are no more better strategies to reduce the risk of equity volatility beyond these. This is true even while investing in equity mutual funds (MF).

Despite, each equity MF being a portfolio of various securities in-line with the fund objective, the ideal way is to create a portfolio of MF which suit the goal being planned. 

This would allow the investor to participate across the market (assuming the various choices of funds spread across the market capitalisation) or in tune with the goal which could include not just equity MF but also debt and hybrid MF.

For instance, while investing for a long-term goal of retirement its ideal to have all or large proportion of the portfolio dedicated to equity but as the need approaches its better to tweak the part of the portion into hybrid and debt MF. This way the volatility in the portfolio is contained while tax efficient investment returns are generated.  

The other important method of extenuating risk in equity MF is to cost average. This is achieved by investing systematically. This could be through a systematic investment plan (SIP) or systematic transfer plan (STP). In the former, the investor would average the cost of acquisition of MF units by investing the future money at a future date.

This could be on a specified date of a particular interval to bring in consistency. This also provides convenience for the investor in accommodating or budgeting this expense at regular intervals. 

So, as the market is dynamic, the investor accumulates higher number of units in a falling markets and lower number of units in a rising market leading to averaging over a period of time. Now, the most prominent logical question is on how long one should SIP in an equity MF.

Multi-year data puts that a typical equity MF on an average generates a maximum return of up to 160 per cent in a year for a SIP while also could generate a minimum return of negative 57 per cent.

The deviation shrinks if the SIP is continued for two years where the maximum return is up to 82 per cent while the minimum posted return is a negative 34 per cent. What is interesting is with the increase in the tenure of the SIP, the risk to reward equation only gets better. The maximum possible return for SIP of three years stands at 54 per cent while the minimum possible return remains at four per cent. 

Of course, these figures reflect an average and are historical performances. I wouldn’t personally recommend only looking at the past data to arrive at choosing a particular fund to invest. At the same time, this data pulls out an interesting insight of how the volatility or deviation in the returns are brought down and leading to a possibility of generating minimum returns which are positive. 

Data also suggests that it’s a 90 per cent possibility of an investor ending up on positive an average in when investing an equity SIP for over three-year period. Now, I wouldn’t again conclude that three years is a sweet-spot for investing in an equity SIP. Preferably, investors should time their investment horizon in accordance to their need to enjoy superior returns and asset allocation.

Discussing the other staggered investment technique, STP, when an investor is sitting with a lumpsum corpus and is unsure of what the market conditions are, then this is a perfect solution. In a STP, the investor parks the existing corpus in a liquid fund and a desired amount is transferred to one or more equity funds of that fund house.

The transfer amount is fixed with a particular interval for a specified period. This automatically allows the investor to average the cost of acquisition in equity MF thus reducing the risk. And if there is a further dip in the markets and suits the investor risk profile, could top-up the STP with switch an additional amount from liquid to equity. This could supplement the STP and reduce the cost of acquisition of units. 

So, a staggered investment philosophy over a diversified portfolio of mutual funds targeting the goals would help achieve the desired results for a disciplined investor. (The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)