How to manage risk in mutual funds

Suppose you're trying to get into shape. You create a routine and make small changes to your lifestyle. One of these key changes is improving your diet.

You could try a crash diet to shed pounds quickly, but soon, you will fall off the wagon. Instead, it's better to focus on a sustainable, rewarding diet. The goal is to feel good about your progress, not dread every meal of boiled chicken and rice.

Similarly, when it comes to investing, there's a unique risk-return level that each investor is comfortable with. If you chase quick returns, it will often be at the expense of peaceful sleep. However, if you take minimal risk, chances are your wealth will grow at a snail's pace. Therefore, you need to have a balanced approach.

In this article, you will learn how to manage risk without compromising on returns. Also, we'll walk you through how risk varies across different mutual funds.

What is risk in mutual funds?

It refers to the possibility that an investor may lose money or earn returns that are lower than expected. Every investment carries some level of risk, and mutual funds are no exception. These risks can be associated with various factors like market fluctuations, interest rate changes, or the performance of the underlying assets in the fund's portfolio.

Types of risk in mutual funds

• Market risk: This refers to the fluctuations in the market, driven by changes in stock and bond prices. Market risk can impact all types of mutual funds, but equity funds are particularly susceptible due to their exposure to stock market movements.
  
• Interest rate risk: This type of risk primarily affects debt mutual funds. When interest rates rise, bond prices tend to fall, and this can impact the value of the bonds held in a mutual fund's portfolio.
  
• Credit risk: This involves the risk of bond issuers defaulting on their payments. Funds that invest in lower-rated bonds face higher credit risk compared to those investing in, say, government bonds.
  
• Inflation risk: Inflation erodes the purchasing power of your returns over time. If a mutual fund's returns do not outpace inflation, your investment could lose substantial value over many years.
  
• Liquidity risk: This risk arises when investors face difficulty selling their mutual fund units quickly without affecting the price. Liquidity risk is more relevant to less-traded funds or those investing in illiquid assets.

Suggested read: Understanding risk in mutual funds

How can you categorise mutual funds by risk level?

Different mutual funds carry varying levels of risk depending on their investment strategy and the type of assets they invest in. Here's how you can categorise them:

Low-risk mutual funds (Best for conservative investors)

Low-risk mutual funds are typically ideal for conservative investors who seek stability and safety in their investments.

• Liquid funds & Overnight funds: These funds invest in short-term money market instruments, short-term corporate deposits, and treasury bills. They offer low returns but come with minimal risk. These funds are used for parking cash for short periods.
  
• Ultra short-term & Short-term debt funds: These funds invest in debt instruments with short durations and offer slightly higher yields than fixed deposits. They are a safer choice for conservative investors, with low volatility.
  
• Gilt funds (Government bond funds): Gilt funds invest in government securities, which carry virtually no credit risk. However, they are sensitive to interest rate changes, which may affect their returns.2
  
• Banking & PSU debt funds: These funds invest in bonds issued by government-backed institutions, offering low credit risk and more stability compared to corporate debt funds.
  
• Large-cap equity funds: These funds invest in stable, well-established companies that have a larger market capitalisation. While they may not have explosive growth potential like mid or small-cap funds, they tend to be less volatile.

Medium-risk mutual funds (For balanced investors)

These funds suit investors with a moderate risk appetite who are willing to take some risk for the potential of higher returns.

• Hybrid funds: A blend of equity and debt, these funds offer a balance between risk and returns. The aggressive hybrid funds lean more towards equity, while conservative hybrid funds have more exposure to debt.
  
• Balanced advantage Funds: These funds dynamically adjust their equity-debt allocation based on market conditions. This strategy allows them to manage market risks while providing the potential for capital growth.
  
• Corporate bond funds: These funds primarily invest in corporate bonds, particularly those rated 'AAA.' While they provide higher returns than government bonds, they also carry moderate credit risk.
  
• Large & mid-cap equity funds: These funds invest in a mix of large-cap and mid-cap stocks, offering stability from large companies and growth potential from mid-cap companies.

High-risk mutual funds (For aggressive investors)

High-risk mutual funds are best suited for investors with a long-term investment horizon and a higher tolerance for risk.

• Mid-cap funds & Small-cap funds: These funds invest in mid-sized and smaller companies that are more volatile but have the potential for multibagger returns. Investors in these funds should be prepared for significant price fluctuations.
  
• Sectoral & Thematic funds: These funds invest in specific industries like technology, pharmaceuticals, or infrastructure. While they offer high returns when the sector performs well, they can also be highly volatile.
  
• International equity funds: These funds invest in foreign markets, which exposes them to currency risk and global market fluctuations. While the potential for growth is high, international funds carry significant volatility.
  
• Credit risk funds: These funds invest in lower-rated corporate bonds, offering higher returns but also higher default risks.

How do you assess the risk of a mutual fund?

Assessing the risk of a mutual fund is essential for understanding how it aligns with your investment goals and risk tolerance. Here are some key metrics to consider:

• Standard Deviation: This metric measures the volatility of a fund's returns. A higher standard deviation indicates greater variability in returns, meaning the fund is riskier.
  
• Sharpe Ratio: This ratio measures the fund's risk-adjusted returns. A higher Sharpe ratio indicates that the fund is providing better returns for the level of risk taken.
  
• Beta: Beta measures a fund's sensitivity to market fluctuations. A beta greater than 1 means the fund is more volatile than the market, while a beta of less than 1 indicates that the fund is less volatile.
  
• Alpha: Alpha indicates the fund's excess return compared to a benchmark. A positive alpha suggests the fund is outperforming its benchmark, while a negative alpha indicates underperformance.
  
• Fund Portfolio Composition: Understanding the fund's underlying assets is key. A fund with a high allocation to high-risk assets will inherently carry more risk.

Suggested read: How to compare mutual funds: Key metrics to consider

What is the risk vs return trade-off in mutual funds?

One of the fundamental principles in investing is the relationship between risk and return. Generally, higher-risk investments have the potential for higher returns, but they also come with the possibility of greater losses. Conversely, lower-risk investments tend to offer more stability but provide lower returns over time.

When selecting a mutual fund, it's important to match the fund with your time horizon and risk tolerance:

• Short-term (0-3 years): Opt for low-risk debt funds to preserve capital and earn stable returns.
  
• Medium-term (3-5 years): Hybrid funds offer a balanced approach with moderate risk and a potential for better returns.
  
• Long-term (5+ years): High-risk equity funds are suitable for long-term investors seeking capital growth, as they can weather market volatility and benefit from compounding over time.

Suggested read: Where should I invest for a time horizon of one to two years? | Where to invest for the medium term?

How can you manage risk in mutual fund investments?

Managing risk effectively is crucial for achieving your financial goals. Here are a few strategies:

• Diversification: Spread your investments across different mutual funds with varying risk profiles to minimise the impact of any single asset's poor performance.
  
• Asset Allocation: Align your asset allocation with your financial goals and risk tolerance. For example, younger investors may allocate more funds to equities for growth, while retirees may prefer more debt funds for stability.
  
• Systematic Investment Plans (SIPs): SIPs allow you to invest a fixed amount regularly, which helps mitigate market volatility and ensures that you buy more units when prices are low and fewer when they are high.
  
• Periodic Portfolio Review and Rebalancing: Regularly review your portfolio to ensure it aligns with your goals. Rebalancing helps to maintain your desired risk level and ensures you are not overly exposed to any single asset class.

Suggested read: Howard Marks' art of risk management

Conclusion

Risk is an essential consideration for every mutual fund investor. Understanding the different levels of risk associated with each type of fund, as well as the risk-return trade-off, is key to making informed investment decisions. By carefully assessing your risk tolerance and financial goals, you can choose the right mutual funds that match your needs.

Investors should regularly monitor their portfolios, maintain proper diversification, and adjust their asset allocations as their circumstances evolve. For those new to mutual fund investing, it's always wise to consult with a financial advisor to ensure that your investments align with your long-term objectives.

Remember, risk management is a continuous process that requires careful planning and periodic adjustments. After all, when you don't lose weight, wouldn't you make changes to your diet plan?

Also read:
Evaluating your risk tolerance
A time for risk? Surely not

This article was originally published on May 13, 2025.