It is usually claimed that you have a higher probability of maximizing your returns if you invest for a long term. That is because of several reasons, the power of compounding being one of them. However, that is not the case always. In fact, as important as a preferred list in investing, there is a list of investments which you must be a tad cautious about. Simply because these schemes or investment avenues may not exactly fit into your long-term investment theme. Some investments just carry too much of risk or will add too much of volatility to your portfolio and hence you need to be doubly cautious.
Here are 5 such investment avenues where you need to be cautious about the risks involved:
1. Sectoral and thematic funds carry concentration risk
When it comes to sectoral and thematic funds, you must ensure to keep these investments as a small portion of your total portfolio. That is because sector funds are focused on a particular sector or industry. We have seen historically that these sector funds have been extremely volatile in tune with the movement of the sectoral cycles. For example, in the aftermath of the IT crash in 200-01, most of the technology funds launched by Indian mutual funds tanked drastically. “The problem was similar with infrastructure funds after the crash 2008. Typically, sectoral cycles tend to last for a number of years and thus timing of entering the cycle becomes important. Additionally, these sector funds also add to your risk concentration so you are better off sticking to diversified equity funds. The argument also applies to thematic funds which focus on themes like consumption, commodities, rate sensitivity etc. While thematic funds are less risky than sector funds, they also go against the basic grain of diversification, which is the cornerstone of a long-term portfolio,” says Vaibhav Agrawal, Head of Research and ARQ, Angel Broking.
2. There is greater credit risk in Credit Opportunities Funds
What exactly are credit opportunities funds (COFs)? They are essentially debt funds which look for yield opportunities in debt that is below the AAA grade. Normally, the risk in government debt and debt issued by blue-chip corporates with AAA rating is quite low. As you go down the credit curve, your risk increases but so do your returns. The problem is something bigger in this case! “We saw that in the case of Amtek Auto where the bond prices fell sharply after the company’s debt was downgraded by a few notches. This resulted in a rush for redemption forcing J P Morgan Fund to almost freeze redemptions. When credit opportunities funds go down the rating curve, the impact of rating shifts can be quite high. Also, these issuers run a fairly higher level of financial risk in their books and hence you are advised to be cautious,” says Agrawal.
3. Insurance endowments and ULIPs are not a great portfolio fit
For a very long time, insurance policies were sold as long-term investments in India. Over the last 15 years, however, it has clearly emerged that your financial plan needs to separate your insurance needs from your investment needs. Endowments are assured return investments that also provide an insurance cover. The challenge from an investor’s perspective is two-fold. Firstly, there is no transparency on the allocation between insurance and investments. Secondly, you end up paying too much for insurance cover and that means your overall investment become sub-optimal.
“Let us look at Unit Linked Insurance Plans (ULIPs). These products are back in the limelight after the 10% tax on LTCG that the Union Budget 2018 imposed on equity funds. ULIPs are currently exempt from this LTCG tax. The problem with ULIPs is again of transparency. The loading in initial years is very high and it will take at least 8-10 years for the investor to earn something reasonable. There is also the risk of mis-selling as investors fail to grasp the difference between a ULIP and a mutual fund,” informs Agrawal.
4. Disproportionate risk in Small Cap Funds
Small Cap Funds are mutual funds that invest in companies with small market capitalisation. While many of these companies have outperformed in the past, the risk element is quite high. Firstly, these companies tend to be too vulnerable to business cycles. Secondly, they are dependent on a handful of customers and hence the risk of disruption is quite high. Thirdly, they do not have the resources and the capital base to see them through prolonged business downturns. You can thus buy small cap funds, but they should be a very small component of your equity portfolio.
5. Little value addition in Company FDs
Company fixed deposits used to be a preferred investment about 15-20 years back when the interest rates were relatively high in India. With rates falling sharply, most corporate FDs pay a very small premium over what you can earn on bank FDs. “For higher returns you need to go down the rating curve and the risk is not worth it. You are, therefore, better off investing in debt funds instead, as they are also more efficient in post-tax terms compared to company FDs,” says Agrawal.
Thus, if you are looking to create wealth through a long-term investment portfolio, then there are some products you need to be cautious about in the larger interests of your portfolio. After all, managing your risk is more than half the job done!