A mutual fund is an investment vehicle where many investors pool their money to earn returns on their capital over a period. This corpus of funds is managed by an investment professional known as a fund manager or portfolio manager.
It is his/her job to invest the corpus in different securities such as bonds, stocks, gold and other assets and seek to provide potential returns. The gains (or losses) on the investment are shared collectively by the investors in proportion to their contribution to the fund.
Why invest in mutual funds?
There are many benefits of investing in mutual funds. Here are some important ones –
Investing in financial markets requires a certain amount of skill. You need to research the market and analyze the best options available. You need knowledge on matters such as macro economy, sectors, company financials, from an asset class perspective. This requires a significant amount of time and commitment from you.
But if you don’t have the skill or the time to delve deep into the market, investing in mutual funds can be an excellent alternative. Here, a professional fund manager takes care of your investments and strives hard to provide reasonable returns.
Returns
One of the biggest mutual fund benefits is that you have the opportunity to earn potentially higher returns than traditional investment options offering assured returns. This is because the returns on mutual funds are linked to the market’s performance.
So, if the market is on a bull run and it does exceedingly well, the impact would be reflected in the value of your fund. However, a poor performance in the market could negatively impact your investments. Unlike traditional investments, mutual funds do not assure capital protection.
So do your research and invest in funds that can help you meet your financial goals at the right time in life.
What are different types of mutual funds?
Debt funds
Debt funds (also known as fixed income funds) invest in assets like government securities and corporate bonds. These funds aim to offer reasonable returns to the investor and are considered relatively less risky. These funds are ideal if you aim for a steady income and are averse to risk.
Equity funds
In contrast to debt funds, equity funds invest your money in stocks. Capital appreciation is an important objective for these funds. But since the returns on equity funds are linked to market movements of stocks, these funds have a higher degree of risk.
They are a good choice if you want to invest for long term goals such as retirement planning or buying a house as the level of risk comes down over time.
Hybrid funds
What if you want equity as well as debt in your investment? Well, hybrid funds are the answer. Hybrid funds invest in a mix of both equity and fixed income securities. Based on the allocation between equity and debt (asset allocation), hybrid funds are further classified into various sub-categories.
Types of funds based on investment objective:
Growth funds
The main objective of growth funds is capital appreciation. These funds put a significant portion of the money in stocks. These funds can be relatively more risky due to high exposure to equity and hence it is good to invest in them for the long-term.
Income funds
As the name suggests, income funds try to provide investors with a stable income. These are debt funds that invest mostly in bonds, government securities and certificate of deposits, etc. They are suitable for different -term goals and for investors with a lower-risk appetite.
Liquid funds
Liquid funds put money in short-term money market instruments like treasury bills, Certificate of Deposits (CDs), term deposits, commercial papers and so on. Liquid funds help to park your surplus money for a few days to a few months or create an emergency fund.
Tax saving funds
Tax saving funds offer you tax benefits under Section 80C of the Income Tax Act. When you invest in these funds, you can claim deductions up to Rs 1.5 lakh each year. Equity Linked Saving Scheme (ELSS) are an example of tax saving funds.
Another tax benefit is indexation benefit available on debt funds. In case of traditional products, all interest earned is subject to tax. However, in case of debt mutual funds, only the returns earned over and above the inflation rate are subject to tax. This could also help investors earn higher post tax returns.
Note:
There are many more categories and types available. I simplified to this level to understand better.
How Mutual funds and investment goals related?
Now that you know the different types of mutual funds, the question arises: ‘Which is the best mutual fund?’
Well, there is no single or right answer to this question. This is because fund houses design mutual funds to achieve specific financial goals. And as an investor, you need to know which mutual funds can help you achieve your goals in the best way possible.
What is Systematic Investment Plans (SIP)?
One of the best features about investing in mutual funds is that you don’t need a large amount of money to start investing. Most fund houses in the country allow investors to begin investing with as little as Rs. 500 (some start at Rs. 100) per month through Systematic Investment Plans (SIPs).
Now, this might seem like a tiny amount to begin your investment journey, but when you invest consistently over a considerable period, you can achieve a substantial sum.
SIP is a method of investing in mutual funds where you invest a specific amount at fixed intervals.
This way, you can avoid timing the market and increase your wealth steadily.
Investing in mutual funds is one of the simplest ways to achieve your financial goals on time. But before you invest, take an adequate amount of time to go through the different fund options. Don’t invest in a fund because your colleague or friend has invested in it. Identify your goals and invest accordingly. If required, you can approach a financial advisor to help you make the right investment decisions and plan your financial journey.
Note: SIP should not be construed as promise on minimum returns and/or safeguard of capital. SIPdoes not assure any protection against losses in declining market conditions.
FAQ
Question: If we can invest directly in stocks and bonds, why do we need mutual funds?
Answer: Yes. You can do that. Not everyone is an expert in stock picking. You need to learn and practice a lot. The stock selection is done very carefully by experts with extensive knowledge. Another reason is the stock price which makes it difficult to invest a small amount.
Question: How risky are the mutual funds?
Answer: The risk depends on the fund category. An equity fund is more risker than a debt fund. Within equity fund, small-cap is riskier than a mid and large-cap, mid-cap is riskier than large-cap. If we compare with other investment options, equity mutual funds are less risky than individual stocks as they work on the concept of diversification.
With the right knowledge about mutual funds, you can mitigate the risk and create wealth.
Question: What is the best time to invest? Should I wait for the market to fall and then invest at a low level?
Answer: Ideally, you would want to buy at the lowest level and sell at the highest level to maximize profit. But nobody knows when will you have the lowest point. Hence, do not wait. Invest now!
Question: Should I invest the lump sum in one go or invest via SIP?
Answer: As mentioned earlier, nobody knows if the market will rise or fall in the near term.The strategy of lump sum vs SIP depends upon the current market situation. If the market is undervalued, then the lump sum investment is a good option. If the market is overvalued then it is better to go for SIP.
Question: How should I select the mutual fund?
Answer: Before you select the mutual fund, you need to shortlist the mutual fund category. Debt mutual funds are low-risk low return category and equity mutual funds are high-risk high return category.
Risk in terms of return where high risk means high fluctuation and even a negative return in the short term when the market falls.
So the first step would be to identify the financial goal with duration and expected amount target. We don’t know if the market will rise or fall in the short term. For any short term financial goal, it is better to invest in low-risk low return debt funds.
For mid to long term financial goal, invest in equity mutual funds with exposure in large-cap, mid-cap and small-cap category.
Question: What to do if the market falls? Should I stop investing and withdraw money?
Answer: You can’t always expect the market to rise, it will rise and fall in the short term but the long term trajectory is always upwards.
Hence, you can take advantage of the market fall by investing more. This would fetch you more units of mutual funds due to lower NAV. Eventually, when the market will recover, you will be rewarded with higher profits.
Also, you need to know more about the market. The above approach will work for selected companies only.
Question: What is an Index fund? Should I invest in Index funds?
Answer: Index fund is a passive style of investing which replicates an Index. For example, a Nifty50 Index fund would replicate the “Nifty” Index which comprises 50 companies.
The investment would be in proportion to the weightage of each company in the Nifty.
The best part of an Index fund is their low expense ratio and hence more return.
Historically, Index funds have been very popular in the developed market. However, in India, the expert’s claim that actively managed funds can provide higher profits as compared to the Index fund and it has been the case in the past few years where a lot of actively managed funds have out performed Index fund.
Please note that currently, the Index funds are only in the large-cap category and the small and mid-cap investment can only be done with actively managed funds.
Question: Why expense ratio is important in mutual fund selection?
Answer: What if you invest Rs 100 and get a return of Rs 10 but finally end up getting Rs 107.5 instead of Rs 110?
This would happen if your expense ratio is 2.5% which is a case in regular funds as it includes both mutual fund house fees and agents commission.
The Index funds, for example, have an expense ratio of as low as 0.05% which means you will get Rs 109.95.
Hence, it is better to go with funds with a low expense ratio. However, if the fund has a low expense ratio but the return is also low then it is not a good option.
Question: Should I select funds on the basis of historical returns?
Answer: No! Do not get tempted to invest in funds only on the basis of historical return. A fundmight provide a great return on a specific year but not guaranteed to provide a great return in the future.
Question: Then how should I select fund?
Answer: A good fund should always be able to beat the benchmark. For example, a large-cap fund would benchmark it against Nifty 100. Moreover, the standard deviation should not be too high. It means the fund should not fluctuate a lot.
Question: How many funds should I have in my portfolio?
Answer: Diversification is very important. However, over-diversification is not bad. A decent portfolio can have 7–8 funds with investment in different fund categories.
Question: How should I start investing?
Answer: First step would be to get your KYC done. Once your KYC is done, you can start investing directly.
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