How about a relatable risk metric?

Processed foods typically mention saturated and transfat per serving. But how will you know whether, say, 20 gram of saturated fat per 100 gram serving is too much? You could face a similar situation with investment products. In this article, we discuss whether asset management companies (AMCs) can disclose risk associated with their mutual funds as a relatable metric.

Relatable risk

What if we are informed that burning fat from consuming ice cream would require us to walk, say, five kilometers at a speed of six kilometers per hour? That way, we can relate to the effort needed to keep good health and yet enjoy such food.

Can we apply a similar argument to investment products?

There are several issues to consider. For one, individuals have different life goals and different time horizons for the same goal. For another, the impact of a shortfall in a portfolio at the end of the time horizon may be different for everyone. Therefore, presenting a standardised set of information could be challenging when you are investing to achieve a life goal.

Consider large-cap active funds. The riskometer categorises such funds as high risk. But what does that mean when you are investing to finance your child’s college education or making down payment for a house? Note that being conservative and not taking risk could also lead to failure of life goals, unless you significantly increase your savings. It will be easier if AMCs disclose a standardised metric in relation to your goal. Suppose you assume that a fund must give 12% annual return (referred to as minimum acceptable return or MAR) to help you achieve your goal. The riskometer could show the frequency during the last 5, 7, 10 years and since inception when the fund gave a return lower than 12%.

That could give a perspective of how risky the fund is in relation to the goal you want to achieve. Note risk is defined as the possibility of earning returns lower than MAR in any year, as that may lead to goal failure. A fund can assume a standardised return regardless of your goals; for MAR is the expected return on equity as an asset class.

Conclusion

AMCs should disclose risk metric in a way we can relate to the information provided. The metric must be standardised for comparison among peer funds. The above argument applies to equity funds with track record, not to new fund offers.

(The author offers training programmes for individuals to manage their personal investments)