How to Select Mutual Funds
Gone are the days when investors blindly stuck to traditional investment instruments like FD, PPF, NPS, etc. to achieve their life goals. With these age-old avenues of investment consistently illustrating a history of suboptimal returns over decades, it becomes even more imperative to break away from the tradition of relying solely on such investment tools and explore the immense field. wealth creation held by mutual funds. This is especially true for millennials, given that they have the age on their side and are certainly more financially aware and keen to unlock as well as understand the potential of mutual funds and how they can ground their journey to achieve. various crucial financial goals in life. So, if you are one of those who are considering investing in mutual funds, it would be prudent to follow these 7 steps to align your financial goals with the right mutual funds and derive optimal returns from them:
1. Identify critical financial goals
The first step in investing your hard-earned money in mutual funds is to identify your critical financial goals. Investments should always be tied to particular financial goals set in life. Before investing, individuals should be clear about the financial goals for which they intend to invest. An investment plan built in the absence of a specific goal leads to erratic decision making and sub-optimal investments. Not only would the list of financial goals and their order of priority vary in all likelihood for each of us, depending on key factors such as age, income and cash flow, number of dependents, etc. different approach to investment planning depending on the associated investment horizon and risk appetite. And when you link and allocate your investments to separate financial goals, it gives direction to the creation of your portfolio and maximizes the potential returns of the chosen funds.
2. Estimate the investment horizon and the target corpus
Your investment horizon depends on your financial goals which are linked to your investment plans. A long-term goal such as the marriage of a child or your own retirement, which involves a longer investment horizon, even beyond a decade or more, would be best achieved by investing primarily in mutual funds of investing in stocks because stocks have always been shown to generate higher returns than all other alternatives such as PPF for long term investments. Whereas, if your objective is short term requiring an investment horizon of only 1 to 2 years, debt funds may be a suitable instrument, as they involve low risk and offer good returns for periods of investment. shorter. In addition, make sure that your financial situation allows you to invest comfortably for the required investment horizon and does not drain you financially.
3. Assess your risk appetite
One of the key anchors that have a huge impact on your investment decisions is your appetite / ability to take risks. Risk appetite is primarily determined on the basis of the stability of your income, your preferred degree of liquidity and the investment horizon to be linked to the financial goals set. All of these parameters determine whether you are risk averse or risk taker, as well as how low, moderate, or high risk you are. Based on the identified risk appetite present at the time of investment planning, investment options are assessed and those that are closest to enabling you to achieve your goals in a timely manner should be chosen. For example, for someone wishing to invest in a long-term goal, such as owning a home after 10 years, the investment avenue chosen would vary depending on their risk appetite. A risk averse investor may prefer to hold a balanced portfolio consisting of a mix of debt and equity funds, while those with a moderate to high risk appetite for the same goals and time horizons would consider investing fully. in equity mutual funds, because stocks have always proven to be the best avenues for achieving long-term goals, offering better returns than other alternative options. In addition, since different categories of mutual funds are targeted and suited to different levels of risk appetite, it becomes imperative to ensure that your risk appetite is identified when selecting your risk appetites. mutual fund.
4. Understand the 2 main categories of mutual funds – Debt and equity
The two popular categories of mutual funds that investors should be clear about before entering the world of mutual funds are debt and equity. Debt mutual funds invest in fixed income instruments like government bonds, treasury bills, corporate bonds, non-convertible bonds, etc. short to medium term.
On the other hand, equity mutual funds invest primarily in stocks and equity-related instruments. This category of mutual funds involves a higher degree of risk and volatility, especially in the short term, due to their sensitivity to economic fluctuations and their involvement in stocks. However, at the same time, they not only hold the potential for high returns, but have also shown through their past performance that they have consistently beaten inflation and the returns of other asset classes by a large margin over. the long-term investment horizon.
Therefore, stocks are proving to be the ideal investment choice for long term goals spanning 5+ years, and to further help investors diversify, equity mutual funds involve different categories such as as large-cap, small-cap, flexible-cap and mid-cap funds. etc., each of which involves different return potential and risk.
Investors can even take advantage of a balance between equity and debt in their portfolio by investing in another category of mutual funds, namely hybrid mutual funds. These funds invest in both debt and equity securities for a balanced portfolio, and therefore are well suited for investors who are apprehensive about embarking on an all-equity portfolio, but want the benefits of potentially high returns from the component. in stocks, while possessing capital protection and stability through investments in debt.
5. Make sure the fund’s investment objectives and strategies match your goal plan.
Once you are clear on whether to go for stocks, debt, or a combination of the two in your mutual fund portfolio, it becomes both prudent and imperative to check the goal and strategies of investing. investment of funds falling into this category. Reviewing the investment objective and strategy of the mutual fund before investing would help to understand whether it would match your risk appetite, your financial goals and allow you to adequately meet the objective by timely thanks to expected returns.
6. Check the past performance of the fund
Another key parameter to check before finalizing a mutual fund is its past performance and how it has changed against its peer funds and benchmarks over different time periods. Checking past performance is a step in understanding whether the chosen fund has been able to withstand the various economic ups and downs of the past and how it has performed against peer funds and the benchmark. However, remember that a fund’s past performance is only an indicator of its potential and does not guarantee the same performance in the future.
7. Consider the expense ratio of the fund
Simply put, a fund’s expense ratio refers to the unit cost incurred in running that mutual fund system. It is calculated by dividing the annual operating expenses (as a percentage) by the average daily net assets of the fund. Since these operating expenses are covered by the assets managed by the fund, a lower expense ratio would imply that a higher portion of your money would remain invested in the fund to enjoy the benefits of future capitalization and growth. .
To get higher returns on their investment, investors should prefer direct mutual fund plans over regular plans because the expense ratio of the former is usually one notch lower than that of regular plans. Therefore, the presence of a lower expense ratio in the case of direct plans is what leads them to generate higher returns. While the degree of outperformance of returns may seem marginal in the early years, the difference has the potential to become substantial in the long run, thanks to the immense compositional power.