Article 2: How to become Rich | How to earn in stock markets | Mutual Funds | Cap Classes

Hi Friends,

First of all, I thank you from the bottoms of my heart for making my first article on stock market a huge success. It has gone literally viral. That encouraged me to be more focused and cautious about my upcoming articles on financial literacy relating to stock markets. 

This is second article in the series. In this, we are going to discuss, What is a Mutual Fund? What is the meaning of Risk and Return? And how to identify your risk class and choose a Mutual Fund so that you can build wealth but you monitor the risk of your investment. It is very important to know about the risk aspects of investment which unfortunately in India relatively poor. People invest money in stock markets based on some tips, advises or with sentiments. News based movements and gambling can cost you a life. So, please understand the risk of investments before you start the game. Trust me, it is fun once u understand the dynamics of game. 

PART 1 : WHAT IS A MUTUAL FUND

What one cannot do, two can do. What one can do, two can do better. Mutual funds are built on these principles.

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realized is shared by its unit holders in proportion to the number of units owned by them.

So, in simple terms mutual funds are professionally managed investment houses. They pool money from public, invest them professionally as per the objectives and distribute the profits to the investors after deducting expenses.

Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sector banks and institutions to set up mutual funds. In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. SEBI formulates policies and regulates the mutual funds to protect the interest of the investors.

PART 2: RISK, RETURN AND TRADEOFF

What is Return?

Return is the short form for Return on Investment (ROI). If you invest money in any type of investment, it’s natural that you expect that you will get more money at a future point of time. By what amount your original amount invested grows is the return on investment to you. For example, if you invest Rs. 1,00,000 in a fixed deposit of a bank and at the end of the year you get Rs. 1,07,000 on maturity your return on investment is Rs. 7,000. Similarly when you invest Rs. 1,00,000 in equity shares of a company and after one year you got a dividend of Rs. 3,000 and the market price of the shares is Rs. 1,18,000 then your return is Rs. 21,000 (dividends and capital appreciation put together). Therefore, return can be in the form of interest income, dividend income or increase in the value of the investment.

What is Risk?

Risk is the uncertainty and variability in the original investment and the return on it. For example if you deposit money in SBI your principal money invested is absolutely safe and the return 7% the rate offered by the bank is guaranteed. It doesn’t depend on the economy, inflation, performance of SBI or any other factor. However if you invest money in equity shares of a company, the market value of the original amount invested is effected by stock markets, government policy, economy, industry, company performance and many other factors. And the return to the investor depends on the financial performance of the company and its dividend policy. Changes in original amount invested and the return on it is the risk.

How to strike a balance between risk and return?

Rule to Remember: One fundamental rule to be kept in mind is that, Risk and Return go hands in glow. That means, higher the return, higher the risk will be and vice versa.

Example: If you invest money in a fixed deposit account in SBI, it gives you around 7% return. If you invest money in corporate debentures, they may offer you 12%. If you invest in mutual funds, they give you 12-24% on average. If you invest in equity shares of a company, it may give higher returns. But remember from SBI to Corporate Debentures to mutual funds to equity shares risk also grows significantly.

PART 3: KNOW YOUR RISK APPETITE:

A retired person of 65 years of age mostly looks for certainty of amount invested rather than play the game aggressively to increase the return. He may choose investments which are less risky or with 0 risk. Naturally the kinds of returns he may make are limited.

On the flipside an employee of 32 years earning Rs. 1,00,000 per month may choose higher returns rather than confining himself to risk free investments. He might earn more than the former but his risk will be higher.

You have to choose the risk and return combination carefully keeping your risk appetite and the financial goals you have. The following diagram will help you in understanding the risk of an investment in a certain mutual fund scheme.

PART 4: KNOW MORE: RISKOMETER

A riskometer is a diagram which depicts the risk profile of a mutual fund scheme. It shows the level of risk associated with the principal amount invested in a mutual fund. It consists  of 5 levels namely

1)      low risk

2)      moderately low risk

3)      moderate risk

4)      moderately high risk and

5)      high risk

Low-risk level

Securities and instruments such as fixed maturity plans, gilt funds and income funds usually come under this classification. These are considered to be the safest mutual funds and are suited for an investor looking for a safe income source.

Moderately low-risk level

Short to medium term bonds usually come under this category. They are considered safe investments and are suited for investors who can stay invested for a period of 1-3 years.

Moderate risk level

It signifies that the funds in this category have their principal at a moderate risk. Instruments such as Arbitrage funds, MIP funds, Hybrid debt-oriented funds. This category of funds are suited for a semi-conservative investor who intends to book decent profits at the same time wants to keep his risk limited. Funds under this label are suited medium to long-term investment horizon.

Moderately high-risk level

It signifies that the funds in this category have their principal at a moderately high risk. Usually, balanced equity-oriented funds, Diversified Equity funds, Index Funds and Gold ETFs are classified under this label. Products under this label are suited for investors seeking to create wealth over a long period of time. Investment in equity under such funds is related to the large-cap segment.

High-risk level

This label means that the funds in this category have their principal at a high risk. Sectoral funds, thematic funds, International funds and micro-cap funds are a few examples of funds under this label. Products under this label are suited for investors seeking to create wealth over a long period of time and are fine with the high risk associated with their bet.

PART 5: CHECK WHICH CATEGORY YOU FALL IN

Similar to the risk labels on the riskometer, investors can also be classified based on their ability to take risks in investments. See which band you fall into.

Risk Level	Investor Type	Nature of the Investor
Low	Conservative	Investor’s top priority is the safety of capital. He is willing to accept relatively low returns against a low risk of principal.
Moderately Low	Moderately Conservative	Investor is willing to accept a small level of risk in exchange for some potential returns over a medium to long-term.
Moderate	Moderate	Investor can tolerate a moderate level of risk in exchange for relatively higher potential returns over a medium to long-term.
Moderately High	Moderately Aggressive	Investor is willing to accept a relatively higher risk to maximize potential returns over the medium to long-term.
High	Aggressive	Investor is willing to accept a significant risk to maximize potential returns over the long terms and is aware that he may lose a significant part of the capital.

Use the new riskometer to choose schemes which are in sync with your risk appetite. This meter is especially useful to investors who are new to the world of mutual funds.

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