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Go Top-Down

Choosing a particular type of fund is more critical than choosing an individual fund within that category…

Last week, I wrote about how and when to exit funds. I’d written that one good way to do so would be to see the whole process as an exact opposite of the way you would make a decision to invest in a fund. Choosing when and in what to invest is a sort of a mirror image of disinvesting. However, it turns out that some of the steps in the investment process have some assumptions that are not very clear. Therefore, this week’s column is a sort of a predecessor to last week’s—it’s about those aspects which tend to be a little less obvious.

The first point was that the decision to invest must be initiated by the need to invest rather than anything external. Depending on what your approach to investing is, this would either sound self-evident to you, or not make any sense. This point is an antidote to the approach exemplified by the statement ‘is this a good time to invest’. This question is the reverse of ‘should I book profits now?’ The answer to that always is that whether it’s a good time to invest depends on whether you have the money to invest. You can’t time the markets, so the thing to do is to choose the right investment and invest in it steadily over a long term.

That brings us to the main question, which is how to choose the right fund. The way to approach this is in a top-down manner. The first stage is to choose the type of fund that you want to invest in. The type of fund is best defined at the first level by its debt-vs-equity allocation. Within equity, the type is best defined by the size of the companies whose stocks the fund typically invests in. Value Research’s fund taxonomy is based on this concept. At the first stage, the most important thing that you could do is to map the time-frame of your investment to the type of asset. Broadly speaking, you should be invested in fixed income for short-term investments and in equity for long-term investments.

It’s important to point out that the definition of short- and long-term here is very different from what is used in trading circles. Long-term is at least three years. This bears emphasising. All investments that you might need to redeem within three years should be in fixed income avenues and not in equity. Beyond that, equity funds are classified by the capitalisation of the companies in whose stocks they generally invest in. Here, the trade-off is on risk. Mid-cap and small-cap focussed funds can deliver higher returns but can also deliver worse losses. Larger cap stocks moderate both.

This is the general framework of figuring out how one should classify mutual funds and what purpose each serves. Only when you have done this does the question of which particular fund to buy. It’s the crucial to understand that choosing the type of fund that you should be investing in is as important (possibly more important) than the individual fund. If you are investing in an unsuitable type, then that’s going to be a problem, even if the actual fund may be the best one within that type.

Even though choosing the right type of fund is so important, it’s largely a do-it-yourself activity. The marketing efforts of fund companies, as well as the sales pitches of fund distributors all concentrate on telling you which individual fund to buy. Unlike choosing an actual product, it’s not an exciting or an entertaining activity to learn the nitty gritty of how to plan your investment in this manner. This makes it all the more important to get this right. This brings us to the final stage of actually choosing the right fund (or set of funds). That’s a story by itself and I’ll write about it in another column in the near future.