equity-mf-&-risk1-min

Equity Mutual Funds and Risk

In Investment Strategy, Mutual Funds by Mitul Daga0 Comments

Many investors shy away from equity mutual funds as they perceive it to be a riskier asset class as compared to more stable asset classes like debt. The main reason being equities are more volatile than other asset classes. No doubt, volatility is an inherent characteristic of equities but that does not imply risk as the main risk which the investors should be concerned about is the permanent loss of capital.

Now, let us see Warren Buffett’s view on volatility. “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments—far riskier—than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.”

Now that we have a fair idea about volatility, let us consider the return aspect. Suppose, an investor puts all his capital in Equity Mutual Funds in the beginning of year 2005 and holds his investment for the next 12 years, it would give us a fair idea about the long term equity returns in Indian markets. This period will also take into consideration the impact of the 2008 bear market when the equity markets plummeted more than 50% from the peak.

Note: CAGR of Nifty index and various categories of Equity Mutual Funds has been shown from 1st Jan 2005.

The above return statistics clearly establishes the fact that if an investor can handle volatility then equity can be the best asset class for portfolio wealth creation over the long term.

Thus, we can conclude that:

  1. For individuals with a long-time horizon, a diversified portfolio of stocks may be the least-risky asset of all.
  2. Investors with a sufficiently long time horizon and a high short-term volatility tolerance could have a high equity allocation and generate a better return than a balanced or debt portfolio.

To summarize in the words of Warren Buffett, “For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities… If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”

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