Equity mutual fund schemes are very popular since they offer higher returns as compared to other mutual fund categories. In January 2024, inflows into equity mutual funds hit ₹ 21,781 crore, which clearly indicates the popularity of equity funds in India. However, the flip side to the high returns offered by equity funds is exposure to higher risk. Read on to learn more about how to invest in equity by considering one’s risk appetite and risk tolerance.
What is ‘risk appetite’ and ‘risk tolerance’?
The two terms are often used interchangeably; however, they do not mean the same thing. An investor begins planning their investment in equity funds by identifying an investment objective. It is important to note that any investment planning revolves around the investment objective, and risk planning is no different in nature. An individual or organisation’s “risk appetite” is the minimum amount of risk that they are willing to take to achieve their investment objective. To simplify it further, it is the “acceptable risk” that an individual or organisation can take while making an investment. “Risk tolerance,” however, is defined as the acceptable deviation from the level set by the risk appetite and investment objective. In simpler terms, risk tolerance sets the boundaries of risk, while risk appetite is the minimal amount of risk that the investor can take.
How to plan one’s risk appetite and risk tolerance while investing in equity mutual funds?
Here is a stepwise procedure that investors can follow to plan their risk appetite and risk tolerance:
- Fixing an investment objective: Even in the case of an individual investor, the most important step is fixing an investment objective. Their objective could be saving to purchase a car or saving for their retirement.
- Determining risk appetite: Risk appetite is a subjective measure and is different for every investor. It is informed by the investor’s income, financial responsibilities and other factors such as debt-to-income ratio.
- Evaluating risk tolerance: Evaluating one’s risk tolerance is easier since it depends on the investor’s time horizon, liquidity requirements, and psychological resilience. Young investors generally have a higher risk tolerance than more seasoned investors.
- Reassessing regularly and diversify: One must continually re-assess their investment portfolio to check if it aligns with their investment objectives and diversify if necessary.
- Using a mutual fund SIP calculator to analyse one’s fund: SIP calculator are free, online tools that help investors plan for their SIP mutual fund investments. Equity fund investors can use this tool to calculate their mutual fund returns at the time of maturity. They can also use it to compare the returns offered by two mutual fund schemes or decide on the ideal investment amount and tenure for their equity mutual fund investments.
Identifying risk tolerance and risk appetite are critical steps in the risk assessment procedure that all investors must follow to improve their returns. Using a mutual fund SIP calculator can also help investors estimate their risk-taking capacity.