The risk of ignoring risk while investing in mutual funds

Several investor surveys indicate that returns are the most important parameter most retail investors rely on to decide which funds to invest in.

When a cricket batsman has to choose between hitting or defending a delivery, one of the important things that he assesses is the risk of getting out. If hitting the ball involves too much risk of losing a wicket, then most likely the batsman would defend the delivery. And this human behaviour of assessing risk and reward is not limited to cricket. It’s prevalent across most spheres of life – be it driving a car, crossing a busy road, or making any business decisions.

But strangely, when it comes to investing, many investors tend to make their investment choices purely based on returns. For example, as per AMFI’s data, in 2020 and 2021, investors were chasing technology and pharma funds, after their strong performance in 2020. Likewise, Small cap funds turned out to be investors’ favorite in 2022 after their stellar performance in 2021.

In fact, several investor surveys also indicate that returns are the most important parameter most retail investors rely on to decide which funds to invest in. In contrast, investors hardly pay heed to understanding the risk characteristics of the fund or the category that the fund belongs to.

So why do investors focus only on returns, and not risk?

The fact that the final outcome for investors is return on investment, it is natural for investors to focus more on it. Moreover, it is also easy for investors to track returns. However, assessing risk in mutual funds is not so straightforward. In fact, the framework that is currently being used to arrive at risk ratings of funds (Riskometer shown in the fund literature) ends up showing the same risk rating for funds across different categories. For example, many funds across categories such as large-cap, flexi-cap, midcap, small-cap, thematic, etc end up having the same “Vey High” rating. Also, the other risk parameters such as standard deviation, beta, etc may seem too complex for investors to understand. These may be some of the reasons why investors do not give enough importance to assessing risk.

Obviously, investing without assessing the risk characteristics of the fund or category is not the best approach. In fact, as a part of the fund selection, it is extremely critical for investors to identify the fund categories that are aligned with their own risk appetite.

Assessing risk associated with fund categories using drawdown metric

Drawdown is the maximum drop in the investor’s investment value and hence intuitively easy to understand from an investor’s perspective. The table below shows (a) the maximum drawdown and (b) percent of investors that have witnessed more than 20/30/40/50 percent drawdown for some of the key categories.

Fund category* Maximum drawdown Percentage of investors seeing a worst drawdown of^
More than 20% More than 30% More than 40% More than 50%
Large cap -59.50% 34.05% 17.97% 6.77% 2.65%
Flexi cap -63.71% 38.50% 23.30% 8.43% 3.39%
Mid cap -69.03% 48.57% 32.84% 14.92% 5.30%
Small Cap -77.14% 73.72% 54.36% 35.61% 21.02%
Technology -65.21% 39.45% 21.71% 17.03% 11.48%
Infrastructure -68.01% 65.38% 41.20% 17.48% 4.59%

Data source: ICRA Analytics. ^ Assuming equal number of investors have invested on every business day. Drawdown data is based on the analysis for the period 01st Jan 2004 to 31st December 2022. Drawdowns for investments made until 31st December 2020 are considered for the analysis to ensure that the investment has completed at least 2 years for assessment of drawdown. Past performance is not an indicator of future results. The benchmark indices used for assessing drawdown of fund categories are as follows (all total return indices): Large cap: Nifty 50, Mid cap: Nifty Midcap 100, Small Cap: Nifty Small Cap 100, Technology: Nifty IT, Infrastructure: Nifty Infrastructure.

Such a drawdown metric can provide a lot of clarity to the investors in terms of what kind of risk/drop in value their investments can experience when they own such funds. For e.g. The worst drop for the small-cap category is -77.14 percent whereas for the large-cap category, it is -59.50 percent. Also, more than 20 percent of the investors have seen a drawdown of over 50 percent in small-cap funds whereas only 2.65 percent of the investors in large-cap funds have experienced drawdowns of such magnitude.

An investor can look at such drawdown statistics and choose a category that aligns with their risk-taking ability. Remember that investing in equity funds requires patience to hold onto your investment for the long-term and not being comfortable with the drawdown you witness in a fund can often make it extremely difficult to stay invested. Following such a data-based risk assessment approach can go a long way in smoothening your wealth creation journey.

The author, Nilesh D Naik, is Head at Mutual Funds, PhonePe