A two-step investment method will help you select the right fund to meet your investment goals: first is by investing your money via a safe route in the stock market, preferably via mutual funds, and second is to create a portfolio that best meets your risk appetite and financial goals.
Let’s understand how you can follow these steps.
What Is A Systematic Investment Plan or SIP And Why Is It Important?
The SIP is a tool to invest in mutual funds in a disciplined manner such that you can achieve your long-term financial goals. This systematic approach lets you invest at regular intervals (weekly, monthly, quarterly, and so on) and helps you create wealth in the long term. However, there is a general misconception that SIPs are different from mutual funds.
Contrary to what many people think, SIPs are not an investment product. They are rather just a method of investing into mutual funds by staggering investments over a period. The money you invest is used to purchase mutual funds units of your predefined choice at the prevalent net asset value (NAV). The current value of your SIP is a product of the total mutual fund units accumulated over the investment period and the current NAV of the mutual fund. The NAV of the fund can be higher or lower depending on the performance of the fund. The value of your investment is therefore directly proportional to the NAV and total units accumulated.
Benefits of Investing in Mutual Funds Through SIP Route
Equity markets are volatile and we all remember the disclaimer at the end of every mutual fund advertisement in India: “mutual funds are subject to market risks, please read all scheme related documents carefully before investing”. This is not to worry you but it is to apprise you of the fact that when you invest in mutual funds, you are subject to market volatility. However, SIPs help you mitigate market risk in many ways, whilst offering much-needed financial discipline.
Among the most widely known benefits of investing through the SIP route is rupee cost averaging. In simple terms, it means averaging out your unit cost in rupees (Refer to the below table).
Total Units Purchased: 1309.1
Total Amount: INR 60,000/-
Average Cost/Unit: 45.8
Third is by far the most important benefit of investing through SIPs is the power of compounding. Over time, the power of compounding helps you achieve your long-term financial goals. However, it is important to note that the benefits of compounding are only visible after following a disciplined investment approach for a long period of about 10 years or more.
Power of Compounding
Kinds Of Mutual Funds You Can Select From
It is paramount to understand that the kind of mutual funds you select will have a direct impact on your overall financial portfolio. Let’s first understand the kind of mutual funds available in the market.
Mutual funds can be broadly classified into three categories:
- Equity-oriented Funds: The main objective of equity-oriented funds is to create wealth which is achieved by predominantly investing in equities i.e., stocks of publicly traded companies. Some examples of equity funds: Market cap Funds (large cap, midcap, small cap, multi-cap), Index Funds, Value Funds, Focused Funds, ELSS -Tax Savings, Sector Funds, etc.
- Debt-oriented Funds: These funds majorly invest in fixed income securities such as government securities, corporate bonds, Bank Certificate of Deposits, Commercial Papers, and other Money Market Instruments. These funds are relatively safer and provide steady returns. Some examples of debt funds: Corporate Bond Fund, Short Term Fund, Credit Risk Fund, Dynamic Bond Fund, Liquid Funds, Money Market Funds, etc.
- Hybrid Funds: If you want the best of both worlds (mix of equity and debt securities), these are the kind of funds that you are looking for. Hybrid funds not only offer potential growth of your portfolio over the years but also help you with income generation. Some examples of hybrid funds include: Equity Oriented Hybrid Funds, Debt Oriented Hybrid Fund, Balanced Advantage, etc.
Apart from the above, there are some other types of funds such as Multi Asset Funds, Gold Funds, Solution Oriented Funds, Infrastructure Fund, Fund of Funds, etc.
A fair idea about the kind of funds that are available in the market is just the starting point. The type of funds you should consider for investment should collectively suit your risk appetite and help you achieve your financial goals.
Create a Portfolio That Meets Your Risk Appetite And Financial Goals
Your investment goals and your risk appetite are directly proportional to each other. If you have aggressive growth expectations, you will need an increased risk appetite and higher risk investments. These investments may reward in the long term, but in the meantime your investments may fluctuate in value and might also have a risk of loss. On the other hand, you may want to preserve your capital which would reduce the investment growth potential. Thereby, your investment goals determine the risk you need to take, which in turn helps you determine which mutual funds to consider for investments.
There are other equally important factors that you need to consider while making investment decisions.
Time Horizon: Your investment horizon has a direct impact on the kind of funds you select for investments. If you are looking to invest for a short term, you can skip equity funds as they are considered high risk investments. Debt oriented funds which focus on safety of capital are best suitable for you. Also, within debt-oriented funds, it is important to look at funds with major investment in securities that have short term maturity (length of time until the principal is supposed to be paid back).
For a long-term investment horizon, growth of capital can be achieved by investing in higher risk investments such as equity-oriented funds. Also, based on your risk appetite, a mix of debt & equity-oriented funds can be considered or even hybrid funds.
Liquidity: Debt-oriented funds can help you meet any planned or unplanned liquidity needs, as they are liquid in nature as they can be sold with little risk of loss. However, equity-oriented funds are less liquid, while they can be easily sold but selling at the wrong time can cause a serious loss.
After considering for all these factors, it is important to define the investment objective as it helps you set investment goals after considering for the risk appetite, time horizon and liquidity needs.
Having determined the type of funds that are suitable for your investments, you need to narrow down a list of six to eight funds for investments. Each category of fund has several mutual funds from different fund houses within them. The goal is to determine funds that are consistent in nature and can help you create wealth in the long term.
Evaluating Funds for Investments (for equity-oriented funds)
It is important to consider a reasonable time frame to evaluate the performance of a fund to make sure that the fund has survived various market cycles and has given consistent returns in the past. Also, it is important to evaluate how the fund performs during market upswings and downswings.
While past performance is important, it is equally important to determine the fund manager’s stock picking capability and his ability to identify trends in the market.
A fund that scores well on consistency backed by a manager who has good stock picking capabilities and can identify sectoral trends should be able to outperform other funds within the category.
Is expense ratio an important factor to be considered?
Expense ratio is the annual fees charged to an investor for management of their money. This fee includes sales and marketing expenses, transaction costs, fund management fees, custodian fees, etc. All such running costs of a mutual fund are collectively called total expense ratio (TER). To protect investors for being overcharged, there are regulatory limits on the total expenses that can be charged by the fund.
For a given fund, are you investing in a direct plan or a regular plan?
Direct and regular plans are two different versions of the same mutual fund. The basic difference between these two plans is the expense ratio. Apart from the other fund expenses, regular plan also includes the commission paid to the distributor by the fund house. In case of the direct plan, since the mutual fund is purchased directly from the fund house, no distribution commission is involved. Thereby, the expense ratio for a direct plan is lower than the regular plan.
While direct plan can yield you, higher returns compared to regular plan, regular plans are best suited for individuals who seek overall investment support and guidance. A small percentage of the additional cost is worth the right investment decision.
Performance Evaluation And Investment Review
An annual performance evaluation facilitates prompt attention to potential performance issues and unintended investment risk. While evaluating the performance, it is important to look at the performance of the fund/category’s respective benchmark to make an informed decision.
Also, any change in your risk appetite, time horizon or liquidity needs should be taken into consideration and an appropriate action must be taken on your overall investments. By regularly reviewing, you can assure that your investments are aligned to your long-term investment goals.
There are several factors that need to be considered before you invest in any fund and there is no one solution that fits all. All investment decisions are unique and should be based on logical reasoning. A good mix of different types of funds suitable for your risk appetite makes sure that your investments are well diversified to help you meet your financial goal without undue risk.