Category : New to Investing December 19, 20235 minutes read
Whether you’re a novice or a seasoned investor, mutual funds can prove to be a good way to increase your potential wealth in the long term. However, you need to know how to choose mutual funds that meet your investment goals and give the maximum return. Investors may choose mutual funds on the basis of several criterias:
- Choosing mutual funds based on goals
- Choosing mutual funds based on risk level
- Choosing mutual funds based on liquidity
In this article, we will walk you through how to choose mutual funds, the types of investment funds, advantages of investing in mutual funds, how to select mutual funds for SIP and other tips and tricks.
There are different types of Mutual Funds categorised by the regulator as mentioned below:
Equity Schemes
Debt Schemes
Hybrid Schemes
Solution Oriented Schemes
Other Schemes
SIPs or Systematic Investment Plans come in different options such as regular SIP, flexible SIP, top-up SIP, trigger SIP, perpetual SIP and SIP with insurance
When deciding how to choose mutual funds to invest in, craft an ideal portfolio after considering your investment objective, investment horizon and risk appetite. It is advisable to get financial advice if you are in doubt
A PPF is an investment that can help you save for retirement. SIPs allow you to invest in mutual funds. If you want stable returns, then PPF is a good choice. If you want to take some risk, then SIPs can help you make potentially better returns.
You may need more diversification if you invest only in one mutual fund, which would subject you to performance-related risks. A portfolio with various funds can help distribute risk and provide longer-term stability and returns
Due to their diversification, mutual funds are typically considered safer than individual equities. Stocks have more risk because they are single assets. Risk levels, however, differ depending on the funds chosen and stock categories selected.
Long-term, consistent contributions to mutual funds can potentially unlock market potential, promote wealth creation and enable achieving goals like retirement or significant expenses.
Introduction
In today’s dynamic financial landscape, choosing the right investment avenue is key to growing your money. The financial landscape has grown leaps and bounds and there are myriad options in the market. Yet, mutual funds stand out as a popular choice for investors seeking diversification, professional management, and potential returns.
However, the world of mutual funds is multifaceted, ranging from equity and bond funds to specialized sectors and strategies. Knowing how to choose mutual funds requires you to have a clear understanding of your financial objectives and a systematic approach to selection. This guide is designed to equip you with the knowledge and tools needed to make informed decisions on how to choose mutual funds, how to select mutual funds for SIPs, learning about mutual fund deduction under Section 80C of the Income Tax Act, 1961 as well as ELSS tax exemption, among other things.
A mutual fund is a financial investment product that pools money from multiple investors and invests them in a diversified portfolio. The portfolio could contain various assets such as stocks, bonds, or other securities. The goal of mutual funds is to multiply the invested sum. These funds are professionally managed by experts.
There are different types of investment funds in the market, categorised depending on their goals and assets. Understanding these in depth will help you learn how to choose mutual funds and advantages of investing in mutual funds.
For instance, mutual funds based on asset classes can be largely categorised into debt funds, equity funds and hybrid funds.
Debt funds primarily invest in fixed income securities like bonds, treasury bills and money market instruments. For passive investors seeking consistent income with low risk, debt funds can be a good choice.
Equity funds invest primarily in equities. Returns are market-linked and hence, funds under this category are considered risky. However, in the long term, equity funds have the potential to generate better returns.
For those seeking a path in between, hybrid funds are a mix of debt and equity.
Based on investment goals, types of investment funds include growth funds, income funds, pension funds and tax-saving funds. Yes, there is a type of mutual fund under Equity Mutual Funds that are tax-saving mutual funds. Also called ELSS, or Equity Linked Savings Schemes, this type of Equity mutual fund qualifies for a tax deduction. ELSS investments are eligible for mutual fund deduction under 80C Section of the Income Tax Act, 1961 of up to Rs.1,50,000 per annum. However, they have a lock-in period of three years.
Advantages of Investing in Mutual Funds
Before we go to understand how to choose mutual funds, let’s explore the advantages of investing in mutual funds.
Diversification
Mutual funds are diversified investments. When an investor invests in a mutual fund, they are also investing in a diverse selection of shares, stocks or bonds. Mutual Funds are an easy way to distribute your assets across various asset classes. This helps spread the risk and prevents you from putting all your eggs in one basket.
Learn more about the benefits of portfolio diversification
Expert Management
Mutual funds are managed by professional fund managers with in-depth financial knowledge. Even if you do not have time to do a thorough market research, you can be rest assured that a professional is handling your funds.
Regulated
Under the Securities and Exchange Board of India (SEBI) (Mutual Funds) Regulations, 1996, the capital markets regulator, SEBI oversees mutual funds. To safeguard investors, promote transparency, and implement a suitable framework for risk mitigation, SEBI has established strict rules and regulations.
Flexible Investments
You can invest in mutual funds in a lump sum or through a Systematic Investment Plan (SIP) in frequent intervals. This will help you inculcate financial discipline and invest as per your convenience.
Save Tax by Investing in Mutual Funds.
Tax Benefits
If you choose to invest in ELSS, you will be eligible for mutual fund deduction under 80C Section of the Income Tax Act, 1961. You can claim up to Rs. 1,50,000 as a deduction per annum.
A mutual fund is a financial investment product that pools money from multiple investors and invests them in a diversified portfolio. This portfolio consists of stocks, bonds and other securities. There are several advantages to investing in mutual funds. Mutual funds allow investors to diversify their assets which may help reduce risk. They may be beneficial for beginner investors due to expert management. Mutual funds are regulated by the Securities and Exchange Board of India (SEBI) to safeguard investors. Most mutual funds are a flexible investment option. Schemes such as ELSS funds allow investors to claim tax deductions.
When it comes down to how to choose mutual funds for investment, one of the first things to keep in mind is to have a goal. Without an investment goal, the advantages of investing in mutual funds may be lost. Any investment should have an end goal in sight.
For instance, if you have a short-term investment goal like saving for a vacation, the benefits of debt funds like stability and predictable returns can make them a good investment choice. For long-term goals like buying a house or saving for retirement, equity mutual funds can be better suited. If you want to save taxes while multiplying your money, ELSS tax exemptions can come in handy.
Your investment goals and investment horizon, i.e. the duration for which you want to stay invested, play an important role in deciding what kind of mutual fund to invest in.
Short-term investment horizon
If your investment goal involves a time horizon of less than a year, then you must invest in less risky funds. Debt funds like liquid funds, money market funds and short-term hybrid funds can be good options. One of the biggest advantages of debt funds is that they are less prone to market fluctuations and can be great investments for goals like an emergency fund or vacation fund.
If you are investing for an extremely short duration, like 30 days, money market mutual fund advantages such as low risk and higher returns than fixed deposits can make them attractive investments.
Medium-term investment horizon
Say you want to buy a car in five years. Or save for the down payment of a house. You have some time to build funds. Here, you can experiment with hybrid funds or balanced funds. They have a healthy mix of debt and equity. This means that you can enjoy the upside of equity investments while protecting from losses through debt investments.
Find a suitable mutual fund at Bandhan Mutual Fund today!
Long-term investment horizon
If your investment horizon is over seven years, then equity mutual funds can be a great bet. Equity investments are volatile in the short term, but when you give them enough time, they can generate potentially better returns. There are even special funds that are suited to specific goals. For instance, if you want to invest for retirement, you can choose to invest in Retirement funds.
Explore the scope of long-term investments in India!
Now that you know how to choose mutual funds depending on your investment horizon, let’s look at how to choose the mode of investment. You can essentially invest in mutual funds through a one-time lump sum investment or through a Systematic Investment Plan (SIP).
SIPs allow you to invest in a mutual fund at pre-decided regular intervals. Wondering how to select mutual funds for SIPs? Depending on your goal, you can make that decision. If you want to invest for retirement or to buy a house, you can identify a fund that has good returns. SIPs allow you to stagger your investment. However, if you find that you have received a bonus and want to invest, you can make a lump sum investment.
Lump sum investments are best made when the market is down, because that way, you can get more mutual fund units.
Investors must identify their financial goals before choosing an investment scheme. Different mutual funds may help investors meet different goals. Short-term investment goals may be met by investing in short-term funds such as liquid funds, overnight funds, money market funds etc. Medium-term goals may be potentially realised by investing in hybrid or balanced funds. Schemes such as equity funds may have an investment horizon of over 7 years. These funds may be suitable for long-term goals.
All investments carry some risk element. To make an informed investment decision, it is imperative to know all risks associated with mutual funds.
o Market Risk (Systematic Risk): Market risk refers to the overall volatility and fluctuations in the financial markets. Factors like economic conditions, interest rate changes, geopolitical events, and broader market trends can impact the value of the assets held within a mutual fund.
o Credit Risk: This risk pertains to bonds or fixed-income securities. Credit risk refers to the possibility that the issuer of a bond may default on interest payments or fail to repay the principal amount at maturity. Lower-rated or “junk” bonds typically carry higher credit risk.
o Liquidity Risk: Liquidity risk in mutual funds is the potential difficulty in selling an investment quickly without significantly impacting its price. If a mutual fund holds illiquid assets or if there’s a sudden rush of redemptions from other investors, the fund may face challenges in meeting withdrawal requests promptly.
o Interest Rate Risk: Interest rate risk affects bond funds significantly. When interest rates rise, the value of existing bonds with lower coupon rates may decrease, as new bonds with higher yields become more attractive. This can lead to a decline in the net asset value (NAV) of bond funds.
o Management Risk: The performance of a mutual fund is heavily influenced by the decisions made by its fund managers. Poor investment choices or a lack of expertise on the manager’s part can lead to underperformance.
Learn more about the types of investment risk and mitigation strategies!
By understanding risk, you can better align your investment portfolio with your risk tolerance and objectives. Diversifying fund types helps reduce risk exposure by balancing the risks and potential returns.
You can decide whether the risk is worth taking by analyzing certain factors:
- Assess your capacity for handling uncertainty to determine your risk tolerance. Analyse your ability, both financially and emotionally, to withstand any losses.
- Match risk to objectives. Accept higher risk when pursuing ambitious goals and less risk when preserving capital.
- Longer investment horizons can withstand short-term market swings. Adjust risk level to investment timeframe.
- Spreading investments among various fund types lowers risk. Choose from different types of investment funds that fit your asset allocation plan.
- Talk to financial advisors to determine risk and create assets that fit your profile.
Risk by Mutual Fund Type
| Equity Funds | Risk Index: High | Equity mutual funds invest in stocks of companies. Their value fluctuates dramatically with market movements. This is why they are highly risky. However, they also have the potential to provide better returns in the long run. |
| Debt Funds | Risk Index: Low to Moderate | Debt funds invest in fixed income securities with predictable and stable returns. They have low risk compared to equity funds. However, debt funds also have risks like credit risks. If the issuer of the bond does not pay, then you stand to lose the money. This is why it is advisable to invest in funds that choose highly-rated bonds. |
| Hybrid Funds | Risk Index: Moderate | Hybrid funds fall in between equity and debt funds on the risk meter. A fund with higher equity investment will carry higher market fluctuation risk. |
All investments carry some level of risk. Investors must consider their risk-appetite and the risk-level of the fund before investing. Some types of risk investors must consider are:
- Market Risk
- Credit Risk
- Liquidity Risk
- Interest Rate Risk
- Management Risk
Liquidity is extremely crucial when you invest in mutual funds. Liquidity refers to how quickly and easily you can convert your mutual fund investment into cash. This is particularly important when you are in urgent need of money. If you have a financial emergency, you should be able to sell your investment instantly.
Liquidity risk refers to the potential for an investment or asset to become difficult to sell quickly without significantly impacting its price. Liquidity risk in mutual funds arises if too many investors want to sell their assets at once. If a mutual fund invests in illiquid assets, then you may run into a liquidity issue.
There are some ways to avoid liquidity risk in mutual funds. For instance, you can research the fund and ensure they have a good redemption history. Check liquid mutual funds returns and then invest. Check the asset composition, fund size and fund manager history.
It is advisable to avoid investing money you may need in an emergency in an ELSS fund. Although ELSS qualify for mutual fund tax deductions, making them an attractive option for tax-saving and long-term wealth creation, they have a lock-in period of three years. If you invest in ELSS to enjoy tax rebate on mutual funds, then you may run into liquidity risk in mutual funds when you need it the most.
Liquidity refers to how quickly and easily you can convert your mutual fund investment into cash. Investments with high liquidity risk may be more risky. Liquidity risk refers to the potential for an investment or asset to become difficult to sell quickly without significantly impacting its price. Mutual funds with a lock-in period, such as ELSS funds, may not be suitable for investors who require cash during an emergency.
When you decide to invest in mutual funds, there are a lot of points to keep in mind. Mutual funds are great investments as long as you understand the different types of investment funds, risks associated with mutual funds and how to select mutual funds for SIP investments, among other things.
Broadly, mutual funds can be categorized into:
- Equity funds
- Debt funds
- Hybrid funds
If you want to enjoy the tax rebate on mutual funds, then you can invest in ELSS for tax exemption. However, do note that ELSS have a lock-in period of three years.
How to choose mutual funds to invest in? Consider your investment goal, investment horizon and risk appetite. Understand all risks associated with mutual funds. Decide your mode of investment i.e lumpsum or SIP investments. Don’t forget to analyze liquidity risk in mutual funds.
If you ever find yourself in doubt, do not hesitate to speak with a financial advisor. They will be able to help you choose mutual funds to invest in that will best fit your requirements.
