Behind the end result of any activity, there is an interplay of various factors. This holds true in the case of equity investments too. While the return from the equity asset class has the potential to beat returns of other asset classes in the long term, there are various risk factors at play. The risk-reward ratio in the case of equity-oriented investments such as equity mutual funds and direct stocks is high. This means, for high returns, there is an element of high risk as well.
The risk in equities could be from various factors and it is seen in the volatility that comes with it. “Equity market is very volatile because of several risks that are associated with it like market risk, inflation risk, currency risk, economic condition risk, specific sector and stock risks and so on. Therefore, it is imperative that one invests knowing these fully well and does not have unreasonable shorter-term expectations and is also ready to accept short term volatilities in the portfolio,” says Col. Sanjeev Govila (Retd), a SEBI Registered Investment Advisor (RIA), and CEO, Hum Fauji Initiatives, a financial planning firm.
However, over a longer horizon, the volatility as reflected in the equity values or NAVs has been seen to remain subdued. What this means and has also been established through various studies that the momentum in the equity values seems to have an upward drift over the long term. This could be the silver lining in the equity investments and long term investors can find solace in this approach.
The stock market as has been seen in the past and even recently can fall over 1000 points in a day, resulting in over 5-10 per cent of the NAV over a short period of time. From global to internal factors, from economic to non-economic factors, the markets can see a sea-saw over a short time frame. However, over the long term, corporate earnings remain one of the strong reason for the stock prices to rise over the long term.
Therefore, choose to invest through equity mutual funds only when your goals are at least seven to ten years away. That said, while nearing goals, one should de-risk and move away from equity to debt funds which are less volatile in nature.
“Equity funds are subject to market risk. One should keep in mind that in the short term that means maybe you know in a short period of 1 to 5 years, their funds can get depleted by 50%. So, that they should keep in mind that if we invest for a longer period of time then we should prefer equity funds. But if it is shorter, they should never gamble or never take the risk. Equities are for the long run,” says Rachit Chawla, CEO & Founder, Finway FSC.
The debt funds, representing the debt asset class, have their own share of risks too. “Debt mutual funds have a relatively lower risk compared to equity mutual funds, but so does the return. As an asset class, they have two fundamental risks – credit risk and interest rate risk. It is possible that a particular fund may have both of these incorporated for getting higher returns or maybe a fund tries to obviate both while accepting lower returns. The investors have to do their own research to decide the kind of balance they are looking for,” says Col. Govila (Retd).
To be on the safer side and take care of at least the credit risk, funds investing in government securities could be ideal. “In credit risk, the fund manager may invest in low-credit rated securities which have a higher probability of default. In interest rate risk, the bond prices may fall due to an increase in the interest rates. You should always go for safe debt funds that are backed by government securities or A+ securities” informs Chawla.
Once you are aware of the risks in equity and debt funds, you will be in a better position to make use of them to create wealth over the long term. Both of them have an important role to play in leading you to meet your long term goals. Behind the returns lies the risks, know them for a smoother investing process.