Saturday, September 27, 2014

Factors to consider BEFORE investing in Mutual Funds


Mutual Funds offer professional investment management at a low cost. It is not possible for most of us to analyze the companies we invest in or to have enough cash to diversify sufficiently to avoid risk of concentration of our investments in a few shares. In India, Mutual Funds are well regulated and the most transparent financial instrument. You get to see the scheme portfolio every month, get daily net asset values. You know that what value you see on screen is what you get! (You will never get me to like ULIPs even if they reduce costs to near zero)

Below are some things to consider before you invest in a Mutual Fund. I talk here about Equity based mutual funds.

Understand the risk and return associated with investment in equity

Investment in equity has its risks. Risk is the chance that an investment's actual return will be different from what is expected. It also includes the possibility that you will lose a part of your capital / investment. The return is not known to you. This is risk. If you have invested in equity funds during the highs of 2007 -08, you have understood the meaning of risk! Usually, people forget what risk is in an upward trending market. However, as seen in the below graph, investment in equity pay off on the long run. Note my use of the term long run. To make it clear, if you have a horizon of 10 years and more, invest in equity mutual funds. You will build your wealth. See this from this article in the Mint. An investment of Rs. 10000 in Dec 1993 in Franklin India Bluechip has grown to > Rs. 8 Lakhs today!!


Don’t invest at random – Invest only with a goal in mind

This is most important thing in any investment. Most people invest randomly in a Fund or anywhere else. First, someone suggests a hot investment – may a closed end small cap fund and says this will get good returns. Then the amount available is invested. At the end of the term or whenever the money is needed, it is withdrawn at random. There is no method. A simple change is needed. Have a goal for which you intend to make the equity investment. If there is no specific goal, let long term wealth building be the goal. Choose the fund, the period of the SIP or the amount etc. keeping the goal in mind. A clear goal along with the knowledge of risks, return and liquidity associated with you investment will cut out the noise and keep you focused. Read this earlier post of mine. You will also choose the right type of Fund once you have a goal in mind.

Take some time to study the features of the scheme you are investing in.

There are several types of equity funds, Large cap funds – investing only in larger companies, multi-cap investing across all market caps, mid and small cap funds which invest in smaller companies to get the benefit of higher growth. Do read the key features of the scheme. Do not blindly go by the name of the scheme. You can have a look at the previous months’ portfolio of the scheme. It is an advisable practice for investors to understand the investment objective of the mutual fund and know the securities in which the investment will be made. Investors should also know the benchmark against which performance will be measured. This can help compare the performance of the selected fund among the peers. This will also provide insights on the expected return and corresponding risk of the investment.

Note the expense ratio - We generally miss noticing the ‘invisible’ fund charges

In return for offering professional management of your money, mutual funds change a fee which is not noticed by you because it is already reflected in the daily value, the NAV. You thus miss how much you are charged. Do look at fund factsheets and see the expense ratio – the % of the assets managed that are charged. This can alter the nature of your returns significantly in the long term. Direct Plans have lower expense rations and are more profitable for you. If you have knowledge of the product and invest in the Direct Plan of a Mutual Fund, it will make a BIG difference in the long term!

Once you consider all this and have read up about the fund, you are ready to invest. Read this on how to use SIP correctly.


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