For investors looking to create wealth through equity investing, mutual funds (MFs) remain the preferred vehicle to amass equity exposure. Handsomely diversified, tightly regulated and extremely transparent, they afford investors an appealing choice to invest aggressively, with confidence. While equity MFs are seen as less risky than alternative investment funds (AIF), portfolio management services (PMS) and direct equity options, it’s the absence of a well-defined risk management plan that almost always derails the wealth creation process.
This is a step-by-step thought process that may enable you to visualize the importance of having a risk management roadmap for your equity mutual fund investments.
The benefit of compounding in equity (that’s the ultimate aim), is realized when you are able to remain invested for more than 20 years. Unfortunately, that’s easier said than done. The reality is that the average equity MF holding period for a single folio is close to two years only! Some of the key reasons why investors fund it hard to remain invested for long periods are volatility ( which can be very unsettling), lack of patience (as markets go through phases of muted and negative returns), the tendency to keep switching to the best performing funds, and the inability to time the market consistently.
Today the performance data for almost all MF schemes are attractive. Large-caps have delivered around 14% CAGR over the last 10 years while small- and mid-caps have returned a CAGR of 20-22%! But remember, you would have made those returns only if you had remained invested in the scheme for that entire period. That’s not easy. People are tempted to buy when markets are rising and sell when markets are falling. This erratic behaviour leads to what is called the ‘behaviour gap’—a phenomena seen world over where investors earn lesser returns than the very fund they invested in! According to a recent study by Dalbar, a financial services market research firm, investors in the US S&P 500 index have underperformed the S&P 500 by 3% CAGR over a 10-year period—that’s 30% more in absolute terms! It’s a lot of money to leave on the table, which is why risk needs to be managed.
Volatility may be managed by portfolio construction. But as seen above, investment results are more dependent on investor behaviour than on fund performance. Thus, investor emotions and expectations also need to be addressed. Managing all these aspects is holistic risk management. And while many investors take the help of professionals, the need for a well-defined risk management plan becomes more apparent after a big loss or as the corpus size gets more meaningful.
All investors are trying to manage risk at a basic level through systematic investment plans (SIPs) and systematic transfer plans (STPs). For instance, instead of deploying a lump sum, an investor may opt for a six-month STP to get a more favourable entry price. However, it’s important to manage risk over the entire life of the investment. Are we using the tools available at our disposal to prudently manage large amounts invested in the market?
A sound risk management framework must address:
Asset allocation: determining your current and desired state of allocation between equity | debt | alternatives;
Rebalancing frequency: A timetable to realign the portfolio back to its desired percentage allocation, thereby maintaining our risk profile.
Drawdown management: What is your investment strategy when markets are crashing? How much drawdown are you willing to take before you panic and sell. Basically, is there a plan beyond simply holding onto your investments during the bad times and waiting for the markets to recover?
Expectation management: The bull market in equities may lull investors into believing that these types of returns are normal and can be expected in future as well. Markets are notorious for not rewarding investors when investors expect to be rewarded! It’s important to manage expectations.
Model portfolio: It’s easier to manage risk on a well-balanced portfolio of 5-7 schemes rather than a lopsided portfolio of 50-100 schemes. A well-constructed portfolio aids a long-term investing plan.
To finish first, you must first finish. The goal is to invest purposefully in equity over decades. Every discerning investor must define and implement their approach to risk management if they are to get to the finishing line.
Kushal Bhagi is owner of PCC Investing.
