Last Updated on 2 years by Mohit Pareek
In recent years, investment in mutual funds gained immense popularity. More people are investing in mutual fund through SIPs or lump sum. Due to the many programs and advertisements run by the government and other financial institutions, the inflow into mutual funds increased manifold.
There are many schemes of mutual funds available to investors. Selecting the best fund scheme is the biggest challenge for every investor. All this forces investors to seek advice from their friends, co-workers or relatives and some even try to find the answer from search engines.
There are many types of mutual funds available to you. Each fund has its merit and demerits. If a particular scheme or fund is suitable for one person, it is not necessarily appropriate for everyone. The fund that best suits your financial goals and meets your risk-appetite is the best mutual fund for you.
Each person or an investor has a different financial goal, different investment time horizons and a different reason for investing. If the investment horizon for one person is 15 years, for another person it may be just 5 years. Even if the horizon of two persons is the same, their financial position, the risk-taking ability may be different. Just remember that no single mutual fund scheme is suitable for everyone.
Instead of searching for the best mutual fund schemes, you should choose the schemes that are best suited for you.
Now, the question arises that how can we know which mutual fund is best suited for us?
Which Mutual Fund is best suited for you?
If you answer these three simple questions, then choosing the best suitable mutual fund is not difficult.
What is your investment goal?
Suppose if you are sitting at the railway station and you do not know where you want to go, then how you can know which train you have to board. Just like that before starting your investment in mutual funds, you have to know your investment goals. Your goal can be buying a house or car, your child’s higher education, your retirement, your child’s wedding, vacation, etc. Many schemes are available but not all schemes are suitable for every type of financial goal. So before investing, know about your goal.
What is your investment horizon?
Time plays a very important role in investment. If you give maximum time to your investment then the chance of getting higher returns increases. You will get the benefit of the power of compounding only if you invest for a long period. Therefore, it is very important to decide your investment horizon before starting your investment.
Your investment horizon can be 1 month or 5 years or 15 years. The scheme which works better for a time horizon of 15 years is not suitable for investment periods of 5 years and 1 month. This is because some funds are best suited for short term and some funds are best suitable for a long term period. An equity fund is best suited for you if your investment horizon is more than 5 years.
Related: 6 Reason to start investing early.
What is your risk appetite?
Every person has different risk-taking abilities. Some are aggressive investors, some are moderate investors and some are conservative investors.
Aggressive investors are those investors who are willing to take risks to earn higher returns. These types of investors invest in schemes that are volatile, risky but capable of giving an amazing return.
Moderate investors are those investors who want to reduce risk and increase their return. These types of investors are willing to take a moderate risk in exchange for a higher return than the rate of inflation.
Conservative investors are those investors who want stability when it comes to investment and is more concerned with protecting their capital than raising its real value.
How to select the Best Mutual Funds?
Mutual fund rating
Mutual fund rating is one of the most important criteria to decide which plan is the best among so many investment options. Many research companies, magazines, news channels and newspapers give their ratings to various mutual fund schemes. The rating is given based on performance, return, volatility and other parameters.
However, the ratings of these mutual funds vary every fortnight or every month. If a scheme has received a 5-star rating in a month, it may be possible that the same fund gets a 3- or 2-star rating in the following month. Even the same scheme gets different ratings for the same month by different research companies.
According to a research company, investors should avoid funds that have received 1-star and 2-star ratings (the lowest rating). Of the total mutual fund plans, approx. 37.5% of the schemes get the lowest rating. This means that you have to choose one of the remaining 62.5% plans.
Many investors invest in mutual fund schemes based on ratings. There is no doubt that research rating is one of the important factors to consider before investing in any scheme, but it should not be the sole purpose of the intervention. You also have to consider other factors such as fund performance, return from the fund, etc.
Consistency of performance
Many investors compare the last 1- or 3 years of past performance and invest in the fund that offered the highest returns over these periods. This is one of the worst ways of choosing mutual funds.
Many funds offered excellent returns in the last 1 or 3 years but if you check their returns for the last 5 years you will find that they performed poorly. Some funds offered 18% returns in the last one year but 4% annual returns in the last 5 years.
Long-term comparisons are the best way to find out how the fund performed in different market conditions. But if you think that the fund which has performed better in the last 5 years will give good returns in future too, then you are wrong. The past performance of a fund cannot be an indicator of how that fund is going to perform in the future. Past performance is examined only to ascertain how the fund performed in different market conditions.
If you want to invest in mutual funds, then ignoring the expense ratio will result in a big loss in your returns. Many investors ignore expense ratios that result in lower returns on their investment. The fund’s expense ratio refers to the fees charged by the AMC for administration, management, promotion and distribution of funds. All expenses incurred in running the fund are included in this figure. High expense ratio affects the returns of the investor. By industry standards, an expense ratio of 1.5% is considered a good deal. Investors are always advised to invest in funds that have low expense ratio so that they get maximum returns in their investments.
Uncertainty can happen to anyone, and at that point, he may need to withdraw his fund, regardless of what purpose he has invested.
At that point, if you are charged a high exit load because you are withdrawing before the maturity period then it is sure that the fund will lose your confidence.
Let us understand what the exit load is and how can you reduce or eliminate it.
Exit load is a cost that is charged by investors if they withdraw their money before the predetermined period (selling units of mutual funds). Typically, a mutual fund charges an exit load of 1% if an investor sells his mutual fund units within a year of purchase. This cost is charged to prevent investors from withdrawing early.
Let us understand by an example. Suppose you have invested in a mutual fund whose exit load is 1% if you sell your unit within 1 year of the investment.
Suppose you redeemed within 10 months of making your investment. If the fund’s NAV during the period of redemption is Rs 100, then the existing fees charged will be 1% of Rs 100 which is equal to Rs 1. After deducting the exit load, the investor will get Rs 99. However, if the investors have completed 1 year or say the stipulated period then they are not required to pay any exit load at the time of redemption.
In the stock market, many investors prefer to invest in penny stocks, so that they can get more units with the same amount, rather than investing in shares of companies that have sound fundamentals and a high price for their stock.
Related: – Why people lose money in the stock market?
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Many investors apply the same principle in mutual funds. They feel that investing in schemes that have low NAV will lead to more units and more profit. As per them, higher NAV schemes are expensive, so they cannot afford to invest in those schemes with a small investment.
Taking an investment decision based on NAV is not the right way to invest in mutual funds. If the percentage return is 10% it means that the scheme whose NAV is 10 will grow by Rs 0.10 and the scheme whose NAV is Rs 100 will grow by Rs 10.
If the NAV is low, you will get more units and if NAV is high then you will get a lesser number of units. Overall, your return will be the same i.e. 10% on your investment.
Let us understand with an example: Suppose you invested Rs 1000 in a fund whose NAV is Rs 10, you will get 100 units. If the growth of the fund is 10% then the NAV of the fund will be Rs 11 and your investment value will be Rs 1100.
Your friend invested Rs 1000 in a fund whose NAV is Rs 100, he will get 10 units. Suppose his fund also grow by 10% then the NAV of the fund will be Rs 110 and his investment value will be Rs 1100.
By comparing both the situation you can understand that NAV should not be the deciding factor while investing in a mutual fund. The investor should check the return on their investment.
A mutual fund scheme that invests in a particular sector or industry is called a sector-specific fund. Infrastructure funds, manufacturing funds, MNC funds, banking funds are examples of sector-specific funds.
Many investors who feel that a specific sector or industry will grow in the future, then they invest in such funds. For example, if someone feels that the banking sector will grow a lot in future, then they invest in the banking sector.
If you make your investment decisions wisely and there is no uncertainty in that sector, then a sector-specific fund can deliver excellent returns in a short time. But in the long run, investing in this type of fund is very dangerous. Many investors lost money in sector-specific funds.
During 2014, many investors believed that the banking sector, especially public sector banks, would grow as the Indian government was serious about improving the health of the banking sector. The government made several policies in favour of banking sectors, which resulted in the rapid increase in the share price of banking sectors. For short-term investors who invested in banking sector funds, they made a lot of money. After a few years when the Government of India felt that it was impossible to revive each bank, they started a policy in which banks would receive funds from the government based on their performance. This means that the bank that is performing poorly will hardly get any benefit from the government.
After this decision, the share price of many banks fell and, in the end, the government decided to merge these banks with other banks. Investors who were enjoying a higher return from the banking sectors suffered heavy losses.
Therefore, one should not consider these types of funds, rather you should choose schemes that invest in different sectors. Even if any sector performed poorly, the return from other high performing sectors will set-off the losses.
Nevertheless, if you still want to invest in sector-specific funds, I recommend that you invest only less than 10% of your investment in these types of schemes.
TIPS from relatives, friends or colleagues
Most investors consult their relatives, friends or co-workers rather than seeking the advice of a financial advisor. It is good to take the advice before making any kind of investment, but we should take advice from those who are experts in this field.
Your relatives, friends or colleagues may offer you investment advice with good intention but you have to do your research before making any investment.
Different Fund Categories
If you want to invest for less 1 Year- Liquid Fund
If you want to invest your surplus fund for less than 1 year, you cannot take any risk. This type of money is set aside to meet upcoming expenses and investors want to earn some extra profit on their idle money compared to their savings account.
For this type of investment, a liquid fund is the best option. Liquid funds are less risky and these funds also protect your capital with some growth.
If you want to invest for 1-3 years- Low Duration Debt Fund
If you have a surplus fund and you do not need it shortly i.e. within 1-3 years, then you can invest in a short-term debt fund. Debt fund is a good alternative for fixed deposits and is more flexible. If you want a better return than a fixed deposit and are comfortable with some risk, then this fund is best suited for you.
If you want to invest for 3-5 years – Hybrid Equity Fund
Investors who have medium-term goals such as buying a car/house within 3–5 years, then they can invest in hybrid equity funds.
Hybrid equity funds are a mixture of equity and debt. Investors who are willing to get the exposure of equity market without taking too much risk can invest in these funds. The presence of equity components in the portfolio provides the ability to earn high returns and the debt component avoids any extreme volatility in the market.
If you want to invest for 5+ years- Multi-cap fund
If you are willing to invest for more than 5 years than equity mutual fund is the best suitable fund for you. Equity fund invests mainly in stocks of various companies and can generate a high return over the long term. This type of investment is highly risky and is suitable for only those investors who are willing to take risks and are willing to invest for a longer duration.
Investing in mutual funds is gaining popularity but many investors choose the wrong fund for various reasons. It is always advisable to understand your financial position, risk appetite and your time horizon before making any investment. Never think that if any fund is suitable for your relatives or friends then it will also be suitable for you.
If you are under 40 and have an investment horizon of over 10 years, you can take some risks and invest in equity-oriented funds.
If you have crossed the age of 40 and your investment horizon is not more than 10 years, then my recommendation is not to take too much risk. It is better to invest in a hybrid-equity fund where you can get better returns with less risk.
Finally, I want to say that never blindly follow someone. This is your money and no one can understand your situation better than you. There is no problem in taking tips and advice, but do your research, check your goals, risk appetite and your investment time. You can take advice from an experienced consultant who can guide you better than your friends or relatives.