The Mutual Fund Advisor: Why understanding risk is more important than chasing returns in mutual funds

But you can understand it and choose the kind of risk that aligns with your goals and nerves.

That’s what we do every day inside Value Research Fund Advisor (VRFA): not to remove risk, but to make it visible, understandable and manageable.Risk is how your money behaves, not a sticker on the boxPeople treat risk as a label: “Low”, “Moderate”, “High”.

If it says “Low”, they think nothing bad can happen.

If it says “High”, they expect guaranteed high returns.In reality, risk is simply: how much your fund can fall, how often, for how long, and what you will do when that happens.Take a typical flexi-cap fund.

In a bad phase, it might fall over 50 per cent from peak to bottom and take around three years to get back.An investor puts Rs 10 lakh into a good flexi cap fund at the start of a bull market.

In the next deep correction, the fund value drops to about Rs 4.3 lakh (a fall of a little over 55 per cent), then recovers over around three years to more than Rs 10 lakh.The real damage usually doesn’t come from that fall; it comes from the investor panicking in the middle, stopping SIPs or exiting near the bottom.

The fund recovers; the investor doesn’t.When VRFA suggests an equity-heavy portfolio, we do it with this historical “normal fall” in mind for that risk level, and we try to prepare investors before it happens.Equity funds: risk shrinks with time, not with prayerLook at an equity fund every day, and it resembles a hospital heart monitor – jagged and stressful.

Over one year, it can easily be up 30 per cent or down 20 per cent.

That is ordinary equity behaviour.Over 7–10 years, those jagged lines smooth out.

Short-term volatility becomes noise; the real risk becomes not owning enough equity to beat inflation.In simple terms, in the short term, the risk is “my money may be worth much less at the wrong time”; in the long term, the risk is “if I avoid equity, my money may not grow enough.”Money kept in a savings account at 4 per cent for 10 years grows to about Rs 15 lakh.

The same amount in a decent equity fund, even with ups and downs, could reasonably grow to around Rs 31 lakh over the same period, based on past equity returns.The lesson is that avoiding volatility at any cost often creates long-term poverty.In VRFA portfolios, we set equity exposure primarily based on time horizon and your tolerance for temporary losses on screen.

If your goal is 12 years away but you cannot digest a 20–30 per cent notional fall, the problem is not mutual funds; it’s a mismatch between goal, risk and temperament.

We adjust the mix so you can actually stay invested.Debt funds: the “safe” ones with their own risksDebt funds look calm, so people treat them like FDs.

But they carry three key risks: credit risk, interest-rate risk and liquidity risk.Credit risk is the chance that the borrower will not pay on time or at all.

If a fund holds bonds of a weak company that runs into trouble, the NAV can fall sharply in a single day.A debt fund with Rs 5,000 crore in assets has 8 per cent in bonds of one troubled issuer.

When that issuer is downgraded or defaults, the NAV can fall 6–7 per cent overnight, and the investor who thought this was an “FD alternative” sees a sudden loss of Rs 60,000–70,000 on a Rs 10 lakh investment.Interest-rate risk is the impact of changing interest rates.

When rates rise, the prices of existing long-term bonds fall, and long-duration funds can show volatility even in the absence of default.Liquidity risk arises when many investors seek to exit simultaneously, and the fund struggles to sell its holdings quickly without taking a hit.Because of these risks, VRFA is very selective with debt categories.

For money you cannot afford to lose, we tilt towards higher-quality, shorter-duration options or very simple choices.

We’re not interested in an extra 0.5 per cent that comes with the chance of a surprise 5–10 per cent loss.The biggest risk is not the fund – it’s us.Here’s the uncomfortable bit: the biggest risk in mutual funds is our own behaviour.Buying a fund just because a friend made money in it last year is a behavioural risk.

Stopping SIPs whenever markets fall converts temporary volatility into permanent loss.

Jumping from one top-performing category to another each year ensures you always arrive after the party is over.There is always a gap between what a fund can deliver if you behave sensibly and what it actually delivers if you behave like a typical investor.VRFA’s quiet job is to shrink this gap.

Our model portfolios are not designed only for maximum theoretical return; they are designed to be livable.

We aim for portfolios that:

And when markets fall, we write to subscribers, explain what’s going on and remind them of the risk they knowingly accepted.

Quite often, this nudge is more valuable than any clever fund pick.A three-question risk testBefore putting money into any mutual fund or portfolio, ask yourself three very simple questions:First, how much can this fall?

Look at how similar funds behaved in past crashes.

A 60-70 per cent fall is unpleasant but normal for an aggressive equity fund, say small cap.Second, how long can it stay down?

Some funds have historically taken about 35 months to recover from big drawdowns, others 5 to 6 years.

If your goal is sooner than that, you’re in the wrong place.Third, what will I do if that happens?

If you know you’ll lose sleep and probably sell, that level of risk is not for you, whatever the past return chart shows.In VRFA, this way of thinking is built into our model portfolios.

We assume investors are human beings with emotions and WhatsApp groups, not robots with perfect discipline.Turning risk into an allyUnderstanding risk in mutual funds is not about memorising jargon.

It is about accepting three simple truths: you need equity risk for long-term growth, debt stability to keep life and near-term goals steady, and behavioural discipline to connect the two.Get that combination right and you don’t have to fear risk; you can harness it.

Your equity funds can do their noisy ups and downs, while your debt allocation and your own behaviour keep you on track.If you don’t want to turn this into your night job, that’s exactly what VRFA is for: turning complicated risk into a simple, usable plan.Returns show up on the fact sheet.Risk shows up in your heartbeat when markets fall.The clearer you are about the second, the better you enjoy the first.(Sneha Suri is Lead Fund Analyst – Value Research’s Fund Advisor)(Disclaimer: Recommendations and views on the stock market, other asset classes or personal finance management tips given by experts are their own.

These opinions do not represent the views of The Times of India)