Investing your money in mutual funds is a great way to gain exposure to the equity markets. With their average annual returns over long-term easily beating traditional fixed income instruments like Fixed Deposits, Mutual funds have become the first choice of investment amongst the millennials and Gen-Zers. However, there’s always a first time for everyone. If you don’t know the basics of mutual fund, how to choose funds and where to get started, this is the post for you. In this blog post, I will explain everything you need to know to get started with mutual fund investments.
Understanding mutual funds
Let’s start our blog post with a basic understanding of what mutual funds are.
While directly purchasing shares or stocks of a company is one approach to equity investing, mutual fund investments offer an alternative route to indirectly access the equity markets.
A mutual fund essentially represents a diverse basket of securities, which can include stocks or bonds from various companies. This selection is typically based on an underlying theme or a broader market index. The specific number of companies included in a particular mutual fund can vary according to the fund’s stated objectives and goals.
For instance, if a fund aims to mirror a broad market index like the NASDAQ 100, it will invest in all 100 companies within that index, maintaining a proportional allocation. Similarly, if the fund’s objective is to focus on high-growth companies, it may select 40-50 companies with substantial growth potential and robust earnings prospects.
In a mutual fund, a group of investors, which could include you, me, our friends, their relatives, and others, contribute their money in denominations ranging from as low as Rs. 500 to as high as Rs. 25,000 per month. This pooled money is then professionally managed by the fund manager of the mutual fund, who buys and sells securities in accordance with the fund’s objectives. Hence, the term – ‘Mutual Fund’.
Who manages your mutual fund?
Mutual funds are managed by professional fund managers of respective asset management companies. These fund managers usually have vast experience and knowledge in dealing with financial markets. Your mutual fund investments can therefore bank upon these fund managers who may choose to buy or sell securities / shares of companies based on their business acumen and insights.
Who should consider investing through mutual funds?
Mutual fund investments are well-suited for individuals who are new to equity investing, including those who lack sufficient time and knowledge to keep track of the financial markets and assess the financial health of the companies they wish to invest in directly. In such situations, opting for mutual funds is a prudent and sensible decision.
How to select the right mutual fund?
First thing, there’s no best or rank #1 mutual fund.
If your primary criterion for selecting mutual funds revolves solely around returns, it’s essential to understand that mutual funds do not offer guaranteed returns. Also, past good performance is not guaranteed to be repeated year after year. Mutual funds are intricately linked with performance of the financial markets.
To select the right mutual fund for your needs, follow this approach:
1.) Define your goals
What is your primary goal for investing money in a mutual fund? Is it to accumulate wealth in the long term? Or is it to park your idle savings for short-term goals like vacations, smartphone purchases, etc.? Defining your goals will help shape your mutual fund selection in the right direction.
If your goal is to accumulate wealth in the long term for goals like buying your dream house or retirement planning, and if you don’t need money back that you’ve invested in the near term, go for index equity funds.
Whereas, if your goal is to fund your vacation or buy that favorite jewelry for your wife on her birthday, consider investing in debt funds or hybrid funds (a mix of equity and debt).
2.) Define your risk tolerance
All mutual funds are subjected to market risks, with potential of both ups and downs in your investment portfolio. If you choose pure equity based mutual funds, your risk exposure will be substantially higher compared to debt based mutual funds. It’s also important to note that risk and rewards are directly proportional. So, higher the risk, more is the possibility of returns. And, the lower the risk, the lower will be the possibility of returns.
As a general understanding, if you’re young and have a stable income, then you should opt for high risk and high reward game. In the long term, it’s likely that the short term fluctuations in mutual fund portfolio value will eventually balance out.
So, what type of investor personality are you? Are you risk averse or risk taker? Your mutual fund selection should align with your investment goals and your comfort level with risk.
Do you need a demat account for mutual fund investments?
No. You don’t necessarily need a demat account to start your first mutual fund investment. Demat accounts are required for buying stocks. For mutual funds, you can either directly open an account with an asset management company of your choice or go with your regular stock broking company.
Types of mutual fund investment strategies
SIP (Systematic Investment Plan) and Lumpsum purchase are two broad investment strategies for mutual fund investors.
Systematic Investment Plans
In a Systematic Investment Plan (SIP), you set an automatic mandate for deduction of a specific amount from your bank account every month on a specified date of your choice. SIP is a disciplined way of investing in mutual funds with benefits of dollar-cost averaging.
Lumpsum investments
In Lumpsum way of investing, you choose to invest a Lumpsum amount of money in mutual funds, as and when you have it. Timing the market, i.e., deciding when to invest your lumpsum money in the market is tricky in this investment approach.
For example, suppose you wish to invest Rs. 1,20,000 in a mutual fund annually. There are two ways to do this:
You can either go with an SIP of Rs. 10,000 that gets deducted on 5th of every month or you can invest the entire sum of Rs. 1,20,000 at once, at a time you that you find most suitable for taking entry into the market.
Direct vs. Regular plans
When you start your first mutual fund investment, you will encounter two options for investment – Direct and Regular.
If you have an investment advisor guiding you, they typically opt for the ‘Regular’ plan when initiating your mutual fund investment. This choice allows them to earn a commission from mutual fund companies and covers their professional fees for guiding, reviewing, and monitoring your investment account.
However, many millennials and Gen-Zers nowadays prefer to bypass intermediaries and open their mutual fund accounts directly with the asset management company. The Net Asset Value (NAV) of ‘Direct’ plans consistently outperforms that of ‘Regular’ plans because they do not include the commission component paid to agents. Consequently, ‘Direct’ plans tend to yield higher returns in the long term compared to ‘Regular’ plans.
Growth vs. IDCW plans
After choosing between Direct/Regular plans, the next crucial decision you’ll make during your initial mutual fund investment is whether to opt for Growth or IDCW (Dividend) plans.
In Growth plans, the profits generated by the mutual fund scheme are reinvested back into the scheme, which can cause the NAV of the fund to increase over time. This can create a compounding effect in the long term, potentially yielding superior profits from your investment.
On the other hand, if you require regular cash flow from your mutual fund investment, it’s advisable to choose IDCW (Income Distribution-cum-Capital Withdrawal) plans. In these schemes, the profits generated are regularly paid out to investors instead of being reinvested back into the scheme. This can provide a steady income stream for investors who need it.
How many mutual funds should you invest in? And how to diversify?
You should ideally invest in 3-4 mutual funds with diverse specialties. For any two mutual funds in your portfolio, make sure that there are not many overlapping securities or stocks in common. Otherwise, your diversification plan may not work.
Understanding mutual fund fees and expenses
Mutual funds are managed by professional fund managers from respective asset management companies, and operating them entails a cost. This cost is typically represented as an expense ratio, a key metric of a mutual fund.
The expense ratio is often expressed as a percentage of the fund’s Net Asset Value (NAV) and may be revised by the asset management company from time to time.
As a general rule of thumb, it’s advisable to select mutual funds with a low expense ratio as this can lead to higher returns in the long term. An expense ratio of 1 or more is generally considered high. Therefore, it’s recommended to choose funds with an expense ratio of less than 1. Choose wisely!
Are you ready?
I hope you found value in this short blog post. And, I am confident that you might now feel confident enough to start your first investment in mutual funds. Should you have any questions, please don’t hesitate in dropping your comments below.
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