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How to Measure Mutual Fund's Investment Risk

How to Measure Mutual Fund

Are you a risk taker or a safe player? In the game of investments, you might find yourself hitting jackpots or falling into pitfalls. Often investors invest with the intent to generate maximum wealth for their invested capital. With this mindset, they overlook the risks involved in the investment. Even though mutual funds are excellent all-around investment tools, they are not immune to risk factors. If your investment is not proportional to the amount of risk involved, then this might be doing more harm than good to you. Calculating your risk before you reach any investing conclusion is a must.

Understanding your portfolio

You have to first understand where you are in your life. There could be many parameters that you will have to look through, like whether you have a dispensable amount of wealth lying at your hand or you have a steady income. You have to understand, why you are investing? What kind of goals you are trying to achieve? There are different plans for different profiles for investing in mutual funds like monthly income investment plans, lump sum investments in mutual funds, SIP online etc. Lump sum investment is investing a complete sum of money at one go. This involves higher risk and is for the people who are fierce risk takers. The other option is SIP or systematic investment planning where money is invested at a regular rotation. It is preferred by people who like to play safe with their money and want a well-organized investment they should understand the risk associated with mutual funds & should consult a fund manager to know which suits your profile the best.

Some risks are unavoidable.

It is important that you thoroughly understand what your fund is doing to lessen the risk. The inevitable risks in mutual fund markets point to a crisis like financial crashes, inconstancy of interest rate or breakdown of a complete division of the market.

Measure the risk.

You can calculate the risk and volatility of your mutual fund and choose a better fund by using the tools. The tools are- alpha, beta, standard deviation, r-squared and Sharpe's ratio.

Alpha

Alpha denotes the value that your fund manager is either adding or subtracting from your return. An alpha of 1.0 means that the fund has outperformed its benchmark index. Likewise, if the alpha is -1.0 then it has underperformed its benchmark index by 1 %. If the alpha is positive, it means the fund manager is adding value to the fund by generating a solid return with the anticipated risk.

Beta

Beta measures how sensitive your fund is to the market movements. It is the measure of the volatility of your mutual fund portfolio. If your fund has a beta value greater than 1, then it is more volatile than the market is and vice versa. So assuming your beta value is 0.70, it denotes lower volatility. Every time the value of 1 rises or falls in the market, your fund rises or falls by 0.70.

R-Squared

R-squared is a measure that depicts the percentage of a fund's movement from its benchmark index. You should always prefer actively managed funds with low R-squared ratios.

Standard deviation

Standard deviation measures the deviation of data from its mean. Higher the standard deviation, higher are the fund's risk. It explains to you how much return from your portfolio is deviating from the return you are expecting which is based on the fund's past performance.

Sharpe's ratio

Sharpe's ratio tells you about how much you are gaining from the mutual fund for the risk that you are taking. It helps you to understand whether the investment’s return is because of the fierce risk factor or smart investment decision.

 

These risk evaluating tools help you to balance your risk-return equation. It is convenient as these are calculated for you and are available on a number of financial websites.

Making a decision

People have different tolerances for risk based on their financial situation. You have to understand your portfolio and what plan suits you comfortably. There is no investment that is wrong except for ones where you jumped to a conclusion without consideration. Your returns depend on the risks, but you can always make good returns if you are smart with your choices. 

 
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