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Financial Planning

How debt and equity based mutual funds differ in risk

13 September 2016
Thought debt and equity mutual funds are equally risky?
 

Mutual funds are one of the most flexible and hassle-free investment instruments that every type of investor can take advantage of.

There are different types of mutual funds based on the level of risk an investor is willing to take, his or her goals, etc. but all of them can be broadly divided into two categories: debt and equity mutual funds.

Both have different levels of risks and as an investor you should know these.

Related: Types of mutual funds and how to start investing in them

What’s a debt mutual fund?

In a debt mutual fund, the majority of the funds are invested in government securities, treasury bills, bonds, money market instruments, debentures, and other “debt instruments.”

In India, the terms debentures and bonds are often used interchangeably. Bonds may be backed with collateral or just the good faith and integrity of the borrower. Debentures are usually backed by the integrity of the borrower.

They’re called debt instruments because the issuer - of the bond or debenture for example - has borrowed money from the lenders (investors). Compared to equity funds the increase in your investment is low since this is a low-risk return investment option – ideal for investors who want a steady income.

Related: Using mutual funds to plan for and fund your child’s education

What’s an equity mutual fund?

Considered a high-risk investment in the short-term, you can expect your investment to grow in the long run. Investors in their prime who are looking for long-term benefits should consider equity mutual funds.

How they differ in risk exposure

Remember, equity funds invest in company stocks and so if you want returns that beat inflation you have to accept the risk associated with these funds. Therefore, when you’re thinking about investing in these funds, stay invested for the long term.

Related: Decoding Inflation for Dummies [InfoGIF]

Debt funds yield a fixed income and have lower risk. If you’re looking for income generation, then look at debt funds. If your goal is growth and wealth creation, then equity funds will better meet your return expectations.

Before you choose a type of fund, determine your investment goal, your time horizon, and your risk tolerance. If you’re a conservative investor, then you should typically choose lower-risk debt mutual funds. If you’re an aggressive investor, then go for medium to higher-risk equity funds.

The middle ground- Hybrid funds:

If you generally like to play it safe but also want high returns from your investments, then hybrid funds would be a great option for you. A hybrid fund is a category of mutual fund that is characterized by a portfolio that is made up of a mix of stocks and bonds. Also for first-time investors, hybrid funds are ideal because they invest in both equity and debt. Equity and debt are diversified across companies and sectors to avoid concentration of risk. The debt instruments in your portfolio will cushion you from the volatility in the equity markets.

Related: Simple ways in which you can diversify your financial portfolio

Equity or debt

Choosing a mutual fund is a decision that you must take based on your appetite for risk. You have to understand what’s important for you to meet your investment goals.

Select funds solely based on data and facts and not personal preferences, uninformed recommendations, brand names, etc. Track fund performances and be aware of your own risk tolerance. Research both equity and debt mutual funds before putting in your hard-earned money into these schemes.

 
 
 

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