You must have heard of the line - “Mutual Funds are subject to market risks, please read the offer document carefully before investing” in every Mutual Fund advertisement. Does this mean all Mutual Funds have risk?
Yes, they do!
What is risk in a Mutual Fund?
Unlike in Fixed Deposits, Mutual Funds do not provide fixed returns. Risk in Mutual Funds refers to the fluctuation/volatility in returns. A Mutual Fund that has given 20% returns in 2017 can provide 0% or even negative returns in 2018.
"Risk comes from not knowing what you are doing." - Warren Buffet
Let us understand this with an example. Say you have invested Rs. 1 lakh each in a Mutual Fund and a Fixed Deposit (Interest rate - 7% after tax) in 2010. The actual investment value at the end of every year is shown below.
As you can see, even though Mutual Funds might have provided higher returns over long term there is a significant risk in the returns they have delivered.
It is also important to note that had you invested in this Equity Fund for 1 year, you would have had a loss of Rs. 20,000 - another example of why you should never invest in Equity for short term
If Mutual Funds have risk, then why should I invest?
Despite the risk and volatility in returns as seen above, Mutual Funds can deliver superior returns compared to other investment options. In the above example, when Fixed Deposits have provided 7% annual returns, the Equity Fund has provide 13.8% annual returns over 7 years. This has resulted in a difference of almost Rs. 90,000 in the returns.
This is precisely the reason why you should invest in Mutual Funds. In a developing country like India where consumer inflation averages at 6%, traditional investments such as Fixed and Term Deposits rarely beat inflation. Hence it is important to include Mutual Funds as part of your investments to generate superior inflation adjusted returns over time.