So you’ve understood the need for investing and have decided that mutual funds are the way to go. Good going! Now, the next question on your mind: how to choose which category of mutual fund to invest in?
Many people often ask, “which mutual fund should I invest in?” This question, unfortunately, has no single answer. This is because the rate earned on your investments in mutual funds is different for different mutual funds. That still sounds fairly easy, isn’t it? One should simply opt for the mutual funds with the highest returns! Wrong. The one rule that everyone must remember when investing is: the higher the return, the higher the risk. Check out a portfolio of high risk, high return mutual funds.
Factors to consider:
Consider the following when you choose which category of mutual fund to invest in.
1. Risk Appetite: How much risk can you take? Can you live through a period of bad performance of your investments? You should consider the following factors when determining your risk appetite:
- + income: how much you earn and save.
- + age: the older you are, the less risk you should take.
- + expenses: daily, monthly, yearly, one time, and so on.
- + financial responsibilities: loans, rent, children’s education, marriage, etc.
- + time frame/tenure: how long you can remain invested.
- + liquid cash: how much money you need in your savings account.
- + life insurance: how well your family is financially protected.
- + health insurance: how well you are prepared for emergencies.
2. Investment Amount: How much can you invest? There are two ways to invest money in mutual funds:
- + Lump sum: This refers to a one-time investment of an amount that you can make in a mutual fund. Often, this is a large amount of money.
- + SIP: SIP, which stands for systematic investment plan, is an arrangement where you invest a fixed amount in a mutual fund every month. Usually, this amount is much smaller and suits salaried people.
How much the invested amount means to you is vital in determining which type of mutual fund you invest in. If the amount is very large, you should stay away from very risky mutual funds. If the amount is small and you’re willing to take risks with it, you can think of investing in risky mutual funds.
3. Time Horizon: This is the period of time you can remain invested for. You shouldn’t be needing the invested money for the said period of time. Needless to say, you should plan your expenses and investments keeping in mind all possible future expenses.
The effect of risk is considered to lower with time. So the longer you invest, the less risky an investment becomes.
Types of Mutual Funds
Mutual funds are of various types. In the following section, you will read about the most popular types of mutual funds based on their investing pattern.
1. Equity Mutual Fund: Equity mutual funds are funds that invest your money only in stocks. Returns on equity mutual funds are the highest among all mutual funds. Don’t forget, equity mutual funds also are the riskiest mutual funds. Based on the kind of stocks equity mutual funds purchase, they are further divided into the following categories:
- Large Cap Mutual Funds: These mutual funds invest your money in large cap company shares. Large cap companies are some of the largest and most established companies. Their market capitalisation is more than ₹200 billion. You can get information about these companies readily in the news. Who should invest? Among all equity mutual funds, large cap mutual funds are considered the safest. Due to the large size and established nature of these companies, large cap mutual funds are considered to be of moderate risk. Check out a portfolio of large cap mutual funds.
- Mid Cap Mutual Funds: These mutual funds invest your money in mid cap company shares. Companies with market capitalization between ₹50 billion and ₹200 billion are referred to as mid cap companies. Often, these companies go on to become large cap mutual funds. Who should invest? Companies in this segment are ones that either grow or fall at a rapid pace. Due to this factor alone, mid cap mutual funds are deemed to be of high risk. Invest only if you have a strong risk tolerance or if you’re investing small amounts. Check out a portfolio of mid cap mutual funds.
- Small Cap Mutual Funds: All companies with a market capitalisation of less than ₹50 billion are called small cap companies. The number of small cap companies in India is very high. This is because India is an upcoming nation. Who should invest? Small cap mutual funds are even riskier than mid cap mutual funds. As is with high risk, the returns in case of such mutual funds can be very high too. Check out a portfolio of small cap mutual funds.
- Small and Mid Cap Mutual Funds: Many mutual funds invest in both, small and mid cap mutual funds. Depending on the discretion of the mutual fund manager, they may hold more of small or mid cap stocks. Who should invest? As you’d expect, the risk in investing in these mutual funds lies between the risk of investing in small cap mutual funds and mid cap mutual funds.
- Sector Mutual Funds: As the name suggests, these mutual funds invest your money only in certain funds. Example, pharmaceutical mutual funds, agricultural mutual funds, etc. Investing in specific industries requires you to have very in depth knowledge and expertise. Who should invest? Sector mutual funds are some of the riskiest mutual funds to invest in. Unless you have very good knowledge and insight of an industry, you should stay away from sector mutual funds.
2. Debt Mutual Fund: Debt mutual funds invest your money in debt or fixed income securities. The returns from debt mutual funds are usually low. At the same time, the risk involved in debt mutual funds is also very low. So far, many debt mutual funds have returned a consistent 7-9% returns in India. Who should invest? If you want to invest a large sum of money that you don’t want to take risks with, debt funds is the way to go. Also, if the time horizon for investment is very small, it is prudent to invest in debt funds. Equity mutual funds are too volatile in the short term and therefore are too risky.
3. Hybrid Mutual Funds: Hybrid mutual funds are funds that invest your money partly in stocks and partly in debt. By doing so, hybrid mutual funds ensure low risk from equity stocks held by the mutual fund. Again, with greater shielding from risk comes lesser rewards. Hybrid mutual funds will give you better returns than debt funds but not as high as equity funds. Check out a portfolio of equity oriented hybrid mutual funds. Who should invest? Are you afraid to take risks in equity mutual funds but desire to earn more than debt mutual funds? You should see if hybrid mutual funds suit them. Hybrid mutual funds are considered to be of moderate risk.
There are more types of mutual funds but if you’re new to mutual funds, knowing the above is a good start.
Determining which mutual fund you should invest is dependent on various factors. Hence, it is hard to come up with a set of rules for how much you should invest in which type of mutual fund. The aim of this article is to help you do just that yourself! You can, of course, take help of a financial planner too who will factor in all these variables and suggest funds for you.
The Relation Between Risk and Time
As the duration of your investment increases, the risk reduces.
Consider how risk reduces with time. Even if you are a very risk averse investor, you should invest in slightly riskier mutual funds if you are investing for a very long time.
Try using this table to understand this better. Based on your appetite for risk and duration of investment, you should consider dividing your mutual fund investments between debt mutual funds and equity mutual funds in the following manner.
You should definitely spend time understanding which mutual fund category you should invest in and how much. This article has hopefully helped you. But remember, each case is different. Your best portfolio will be determined by you.