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On May 23, 2024, the value of stocks on the National Stock Exchange (NSE) or its market capitalisation, touched the landmark of $5 trillion* (about Rs 4.19 lakh crore). Now, juxtapose this landmark for one of world’s top stock markets with latest Reserve Bank of India (RBI) household savings data, released in September 2023. It indicates that in March 2021, bank deposits were 47.63%** of total financial assets and were the most popular financial savings option, not equities.
Fixed income and other debt investments have their own distinct risks.
Interest rate risk Debt investments are sensitive to changes in interest rates. Their values decline when interest rate rises and vice versa. Typically, longer the period, greater the interest risk and volatility, due to interest rate changes. However, in India, this impacts investors of market-linked investments like bonds, not FDs. There have been instances*** when investors have faced this risk with issuers retiring bonds due to declining interest rates.
Reinvestment risk This is a risk related to reinvesting maturity proceeds. During rising interest rates, after reinvesting in an FD, investors can witness new FDs offered with higher rates. During declining rates, the challenge is to reinvest at the highest possible rate.
Credit risk This is the risk of not being repaid in part or full, the returns and principal amount. While India has never experienced large scale bank failures as in the West, especially during Global Financial Crisis of 2008, yet there have been prominent cases# with greater occurrence in company deposits##. Remember, only deposits up to Rs 5 lakh including interest, are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC) ### with no such protection for company deposits.
Inflation risk This is the risk that returns from debt investments will lag inflation rate. Over the 10 years of 2014-23, the average interest rate of FD of 1-2 year tenure was about 6.7%^ compared to inflation of 4.98%^^, with FD rates lagging inflation during three years of high inflation from 2020 to 2022.
With these reasonably evident risks in debt investments, how do investors end up overlooking them? Let s try and explain this phenomenon.
Investors often mix up risk and volatility. In plain speak, risk is the difference between expected and actual returns. Greater the difference, greater the risk. Volatility can be explained as the rapid changes in price or value of the investment in a short period of time.
An investor will want to minimise the divergence between expected and actual returns. But it is also true that investments with large divergence such as equities and equity mutual funds typically offer high return in the long term i.e., 8-10 years or more, after riding out short term market turbulence. During the last 10 years, simplest equity investments represented by index funds based on a large cap index like Nifty 50 offered returns of 13% per annum during 10 year Nifty 50 index fund returns on July 15, 2024
The truth is that every investment has risks associated with it. For equities, it is investor sentiments, domestic and international developments, company related developments like financial performance. For real estate, it is the age of property and other property-related conditions, economic conditions, and market price movements. For physical gold, it involves safety, purity, and storage.
While risk is associated with every investment, equity investments like those in equity mutual funds, undergo periods of more pronounced volatility than debt investments that last for longer periods. So, how do you select the right investments?
An investor needs to ensure the right mix of investments across asset classes to minimise fluctuations in overall returns of the portfolio. Experts call this asset allocation which helps achieve more consistent returns and large savings.
During asset allocation, lesser the time at hand, lower should be the volatility of investments. This is the reason debt investments are appropriate for shorter term needs i.e., arising in 1-4 years, such as emergency expenses, securing long term gains of investments and creating regular income. Needs arising in four or more years need some equity investments to counter inflation, with long term needs in 8-10 years or more, being ideal for solely equity investments.
Individual investors typically do not have the time and expertise for evaluating and managing risks. Here, mutual fund investments can help with expert fund managers providing the right combination of investments. An investor can invest in different asset classes with different mutual funds like equity mutual funds and debt mutual funds. They can also invest in hybrid mutual funds such as balanced advantage funds and multi asset allocation funds which invest in different asset classes and keep rebalancing their portfolios.
Investments in equity mutual funds and equity-oriented hybrid funds like balanced advantage funds also get to exploit volatility using SIP, with SIP full form being Systematic Investment Plan. This involves regular investment of a pre-decided amount, with amounts as low as Rs 500, in a mutual fund scheme.
SIP investment process helps investors buy more units when the market is low and less units when the markets are high. Consequently, the average cost of buying units becomes low in the long term and they gain when the markets rise. SIP also helps you accumulate money for emergency and short term needs.
Another great feature of mutual fund investments is the mandatory visual risk labelling with Risk-O-Meter. It needs to be present in all investor communications like brochures and advertisements. Any mutual fund, regardless of being debt mutual funds or equity mutual funds, needs to be labelled according to six risk levels based on risk score. The risk levels in ascending order are low risk, moderately low risk, moderate risk, moderately high risk, high risk and very high risk. This feature provides a key input on risk for an informed investment decision.
To sum up, investing is like a sea voyage. You do not get intimidated by the sea waves and with the right kind of boat and sailing expertise reach your destination.
** https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/50BT_180920233362BD9DD67443E88CE4EBBFA6D71475.PDF
^https://sbi.co.in/web/interest-rates/interest-rates/deposit-rates, FD rates for 1-2 years first announced in a calendar year
^^https://www.statista.com/statistics/271322/inflation-rate-in-india/
$https://www.amfiindia.com/research-information/other-data/mf-scheme-performance, details for 10 year Nifty 50 index fund returns on July 15, 2024
An investor education & awareness initiative.
The above is only for understanding purpose and shouldn’t be construed as investment advice provided by the AMC. Consult your financial/tax advisor before taking investment decisions. The % of return, if any, mentioned in this article will depend upon various factors including the tenure of investment, type of scheme, prevailing market conditions, view of Fund Manager on the market etc.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
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