Chapter 13. Helping Investors Understand Risk in Found Investing

  • The right level of risk tolerance of any investor depends upon his age, the amount of inevitable funds available and his financial circumstances including income level, job security, family size etc.
  • Investor should be categorized into low risk, moderate risk and high risk categories

Low Risk Fund:

  • Money market funds
  • Government securities funds

Moderate Risk Funds:

  • Income funds
  • Balanced funds
  • Growth and income funds
  • Growth funds
  • Short term bond funds
  • Intermediate bond funds
  • Index funds

High Risk Funds:

  • Aggressive growth funds
  • Intermediate funds
  • Sector funds
  • Precious metals funds
  • High yield bond funds
  • Commodity funds

Jacobs recommends the following portfolio

  • Low Risk (Conservative) Portfolio
    • 50:50 Govt securities : money market funds
  • Moderate Risk (Cautiously Aggressive) Portfolio:
    • 40% in Income Fund
    • 30% in Govt Bond
    • 20% in Growth Fund
    • 10% in Index Fund
  • High Risk (Aggressive) Portfolio:
    • 25% in aggressive Growth
    • 25% in international Funds
    • 25% in Sector Fund
    • 15% in High Yield Fund
    • 10% in Gold Funds

Standard Deviation (SD)

  • Risk is measurable by the statistical concept of standard deviation
  • SD measures the fluctuations of a fund’s returns around a mean level
  • SD basically gives you an idea of how volatile the earnings are
  • SD can compute for both equity and debt funds, SD of different funds can be compared with each other, or with SD of a market index or even that of another category

Beta Coefficient

  • This also measures the fund risk
  • It relates a funds return with a market index and measures the sensitivity of the funds returns to change in the market index.
  • Higher beta gives greater return in rising market and vice versa
  • Beta is based on past performance and it doesn’t indicate the future performance
  • Fund with the specialize portfolio (sector) can’t be assessed by beta based
  • Beta measures sensitivity of the funds returns to changes in the market index
    • Beta of 1: Fund moves with market (Index Fund)
    • Beta < 1: Less volatile than market (Conservative portfolio)
    • Beta > 1: Higher volatile than market (software fund)

Bogles’ ExMarks or R-Squared:

  • R-squared measure how much of a funds fluctuations are attributable to movements in the overall market from 0 to 100%
  • Like an index fund will have ExMarks of nearly 100%
  • ExMarks measures Funds performance in relation to the benchmark index.
  • It is given from 0-100. With 100% meaning highest relation like an index fund has ExMark of 100%
  • If ExMark is lower than 80%, fund is less than predictable in relation to index and may be riskier
  • But, overall SD is the best measures of risk

Sharpe Ratio:

  • It gives risk and return relation
  • Higher the Sharpe ratios better the fund
  • Sharpe ratio indicates the quality of returns
  • It shows the return given by fund per unit of risk it takes
  • William Sharpe created a metric for fund performance, which enables the ranking of funds on risk-adjusted return basis.
  • This measure is based on the comparison of “excess return” per unit of risk, risk being measured by standard deviation
  • Excess return is defined as the actual return of the fund less risk free rate.


  • It compares the funds actual results with what would have been expected give the funds beta and the market index performance
  • It is the difference between a security’s expected return and its equilibrium expected return
  • Positive alpha indicates undervalued securities
  • Negative alpha indicate over valued securities
  • Alpha gives the incremental returns over the expected returns
  • It calculates what should be expected returns for the fund given the realized risks of the fund.
  • Higher the ratios better the fund

Treynor Ratio:

  • Treynor Ratio measures the fund performance in terms of market risk
  • Higher the treynor ratio better is the fund. It shows how much more return a fund has given, per unit of portfolio risk it took.

Price/Earning Multiple (P/E):

  • P/E = Market price per share / Earnings per share
  • Higher the P/E as compared to the market, higher the probability of its fall in the future
  • Low P/E ratio indicates that the securities of the fund are undervalued
  • It is a simple risk measure
  • Fund P/E ratio – Weighted average of P/E ratio of all the stock held in the portfolios

Expense Ratio:

  • The expense ratio is an indicator of the funds efficiency and cost effectiveness
  • Expense Ration = Total expenses / Average Net Assets of the fund
  • Expense Ratio excludes brokerage commissions as brokerage commission has to be capitalized as per SEBI
  • Expense ratio has to use for average of 3 to 5 years to judge the performance of the fund
  • Expense ratio evaluated in the light of fund size and portfolio composition

Income Ratio:

  • Income Ratio = Net Investment Income / Net Assets
  • It is useful for evaluating debt funds

Portfolio Turnover Rate:

  • It is the amount of buying / selling in the market
  • It is useful to judge the transaction cost of fund
  • It is useful in analysis of equity and balanced funds

Transaction Costs:

  • It includes brokerage commission, stamp duty, registrar’s fees, custodian fees, dealers spreads

Debt Funds:

  • Debt funds are exposed to credit risk, risk of borrower defaults and interest rate risk that comes from the average maturity of the funds portfolio
  • The longer the maturity of a portfolio, the greater the risk it has from interest rate fluctuations

Fixed Maturity Plan (FMP):

  • To those investors who like to buy a bond and hold it to maturity, without talking any market risk, the FMP is an ideal choice
  • FMP is like a Fixed Deposit (FD) with additional convenience and liquidity of a Mutual Fund
  • They are like FD product with the difference being that the interest rate is not known in advance
  • Whereas in case of a FD, the deposit holder is aware of the maturity and the interest he will be earning
  • FMPs have a fixed time horizon as the maturity of the scheme, e.g if one invests in an FMP with maturity of 1 year, at the end of the year, the money and the earnings are returned to the investor.
  • FMPs invest in short term corporate paper and AAA rated long term corporate bonds
  • This help fund to avoid unnecessary churning in the portfolio. As investments are held till maturity, there is no interest rate risk.
  • FMPs at maturity tend to pay returns as dividend, which are taxed at lower rate than those for interest payment on FDs
  • This along with indexation benefit helps investor to get better returns on post tax basis than FDs
  • FMPs are available for subscription only during the period of launch with maturities ranging from 3 months to 5 years
  • FMPs with 1 year maturity is most popular
  • NAV is declared on a daily basis any withdrawal before maturity is subject to an exit load.

Floating Rate Plan:

  • This plan focuses on debt instruments which have a floating interest rate.
  • Hence it seeks to protect the portfolio from the fluctuations arising out of changes in interest rates.
  • It helps the investor earn a steady leveled of market return comparable to a liquid fund

Long Term Floating Rate Plan:

  • Apart from seeking to protect the portfolio from market risks, the long term floating rate plan also seeks to capture the benefit of loading interest rate by investing in bonds where term rate of interest is periodically fixed.

Income Plan:

  • Income plan invests in a basket of debt securities of various maturities that seeks to maximize income while at the same time maintaining the optimum balance of yield, safety and liquidity

Flexible Income Plan:

  • Flexible income plan may be ideal if one wants to take advantage of fluctuations in the debt markets for it has the flexibility to shift investment to debt securities with higher or lower maturities depending on market conditions
  • The fund seeks to actively manage the interest rate risks

Income Multiple Funds (IMF):

  • IMF scheme enables you to enjoy the highs of equity investing along with the cushion of the relative safety of debt investments
  • That’s because a minimum of 70% is invested in debt and up to 30% of your money is put in equity to make it work harder for you.

Monthly Income Plan:

  • This is an open ended fund. Monthly income plan doesn’t means investor as surely get monthly income
  • If you like a steady growth in your portfolio, or desire a regular income stream periodically, the monthly income plan is ideal for you.
  • It invests in good quality debt instruments to generate income, and a small allocation of 15% (Max) to equity, to ensure some growth.

Measure of Bond Yields:

  • Current Yield = Coupon Rate / Current Market Price
  • Yield to Maturity (YTM):
    • It’s also known as bond’s IRR
    • It is annual rate of return
    • Investor would realize if he bought a bond at a particular price, received all the coupon payments, reinvested the coupon at same YTM and received the principal at maturity.
  • There is inverse relationship between price and YTM of a bond

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