Have you ever read the statutory warning on every cigarette pack: Cigarette Smoking Is Injurious To Health?

In the same vein, every single mutual fund offer document will carry the caveat: Mutual Funds Are Subject To Market Risks.

Just like ardent cigarette smokers who chose to ignore this warning, investors too will look the other way.

Ever wondered what it meant?

Market risk refers to the possibility that your investment in a mutual fund can go down in value over a period of time. That's right. Understand that you can earn a negative return by investing in a mutual fund. It is not always great (positive) returns.

Does that mean one should not invest in mutual funds because they are subject to market risks? Not at all!

Investors tend to focus only on returns when investing in mutual funds. I will refrain from quoting returns here as I strongly believe they skew the investor's perception without giving due respect to risk. And I am confident most of us are exposed to different versions of numbers through friends, family, the media and mutual fund agents.

I believe the focus on returns is very one-sided and has exposed majority of the people in the market to undue risks. Investors who saw the market fall from 12,600 to 9,000 levels will understand this better.

So, invest in mutual funds but do it in alignment with your risk profile. This indicates your capacity to take risks and the amount of risk you can tolerate (ability to sleep well during turbulent markets). Accordingly, allocate your savings to various investment avenues (asset allocation).

The ability to do so is far more important than purely looking at the Sensex levels and taking an investment call.

People generally want to invest in funds by asking just one question: Which ones have delivered the highest returns this year? There are an equally large number of people willing to provide an answer.

But an equally important question that is never asked is: What risks has this fund taken to generate those returns as compared to other funds?

To answer this question, you also need to ask:

Does this fund have a concentrated portfolio of just a few stocks?

Are investments concentrated in a few sectors?

Does it have a have a high portfolio turnover (buys, sells and churns its stocks very often)?

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Think long-term

I often come across (terribly wrong) statements that Unit Linked Insurance Plans are long-term investments but mutual funds are short-term. Nothing could be further from the truth.

Mutual funds are outstanding long-term investment products and big money can be made in mutual funds by systematically and consistently investing over a period of time. You need to stay invested over several business cycles which could span 10, 20 or even 30 years. 

Though there might be declines or even corrections in the shorter term, over several business cycles, equities have proven to be the best asset class in terms of risk adjusted returns (when you take risk into account to evaluate returns).

Which brings us to: How does one invest in mutual funds in alignment with the risk tolerance and financial goals?

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Making the right choice

Here are 10 pointers that one should follow.

1. Listen to Socrates when he said 'Know thyself'. While he was referring to the key in human advancement, it can well be applicable to your financial advancement. Get a handle on your financial goals and needs.
   
2. Evaluate what kind of returns you would need to earn to achieve your goals. Be realistic in your expectations.
   
3. Look at investments in diversified equity mutual funds for longer terms goals, those with at least a five to 10 year horizon. If your time horizon is three to five years, you can look at balanced funds which invest up to 65% in equity and 35% in debt.
   
4. Consider New Fund Offerings only if there is something unique about the new fund and only if it complements your current investments.
   
5. Give sector funds a miss unless you are bullish on a sector, understand the risks and choose to take on the risks for extra returns.
   
6. Avoid churning (frequent buying and selling) of your funds like a day trader.
   
7. Don't get fooled by the 'only Rs 10 NAV' spiel. There is no difference between a Net Asset Value of Rs 10 and Rs 100. A mutual fund is always sold at par and a Rs 100 NAV indicates the competence of the fund manager.
   
8. Invest in a systematic fashion every month and especially at every decline (if this is possible).
   
9. Be a consistent investor, not an erratic one.
   
10. Sell only when you need money or if something has gone fundamentally wrong with your investments.

Amar Pandit is a certified financial planner and runs the Mumbai-based firm My Financial Advisor.