Confused about mutual funds? The 7-5-3-1 rule makes it easy

Summary: SIPs are the smartest way to build wealth. But many people make a ton of mistakes with this route. That’s why we’ll walk you through a simple but effective framework called the 7-5-3-1 rule. It will help you level up your investment plan.

There’s an infamous book on running. Termed as “The Ultimate Guide to Running”, you’d imagine it would be filled with interesting advice and anecdotes, right?

Well, all it has is “Left foot. Right foot.” – written page after page.

Absurd? Maybe. But it highlights a deeper truth: the simplest advice is often the most effective. And investing wisdom is no different.

People overcomplicate wealth-building, but what really works is a simple framework executed patiently.

One such framework is the 7-5-3-1 rule in SIPs. It is easy to understand, but there’s quite a bit to unpack in it, with each number relating to a guideline. In this article, we’ll explain all its guidelines and how you can implement them. 

Let’s walk through the basics of the 7-5-3-1 rule in SIPs.

7 - Deciding on your time horizon

If you ask your friends and family what counts as a long-term investment, you’ll notice that the answers will vary widely.

Some might even cite the tax definition and say that one year is enough for an investment to grow.

However, it is essential to understand that when you’re investing for the long run, you’ll need to put your money in equity. This move will help you retain your purchasing power and grow your corpus effectively. And equity requires time – a lot of it.

According to the framework, seven years is a minimum. Having a substantial time horizon will help reduce the impact of the short-term volatility commonly associated with equity funds.

However, we advise you to retain your investments for a longer time if you’re investing in small-cap or mid-cap funds. These take a longer time to reach their escape velocity, so to speak. This is because these funds invest in high-growth companies.

Many of these stocks will go through bouts of intense volatility. In addition, there’s a risk that some of these businesses will go bankrupt during particularly tough down-cycles. For you to witness the power of compounding in these funds, you need to have an extended time horizon that allows you to wade through this volatility and risk.

Suggested read: The hardest part of investing is waiting

5 - Building your portfolio

Once you’ve accepted that investing needs time, the next question is: how should you build your portfolio?

Most people have a tendency to clutter their portfolios with funds. One of the reasons is that there is a series of NFOs (New Fund Offerings) taking place every week, and each fund is marketed incessantly. Naturally, new investors get caught up in the excitement and buy the new fund without a thought.

Such people become collectors rather than investors.

However, the framework gives a clear guideline that goes against this form of overdiversification. It suggests that you keep only five different categories of equity funds.

We advocate keeping diversified investment vehicles, such as multi-cap and flexi-cap funds. Hence, our suggestion is to avoid including sectoral and thematic funds.

While these exotic fund categories have done rather well, a new investor should focus on broad market exposure. These funds should act as a complement to your portfolio and not the core.

Suggested read: Sectoral delusions

3 - Enduring market volatility

Running requires endurance. Similarly, as an investor, sticking with your mutual fund holdings through market ups and downs is going to be the real challenge. And you need to analyse how you respond to different market extremes. This requires being honest with yourself.

New investors will generally be super excited if the markets soar soon after their first investment. As a result, they’ll sell their units in a market high to make a quick buck. This is a common response driven by fear that the market will come down soon after; so, they sell while the market is still up.

Additionally, when the markets fall, people will again sell. But this time, panic drives their decision-making.

In both cases, an investor walks out of the market before making real gains. Thus, based on these two scenarios, we can easily conclude that successful investing requires a different mindset. That’s why the framework charts out three psychological hurdles that every investor deals with:

1. Disappointment: Losses happen. Instead of quitting, reassess your decision and refine your judgment.
2. Frustration: Good funds need time. Don’t exit early before compounding works its magic.
3. Panic: Market crashes are temporary. Resist impulse selling if your investments are well-researched.

Suggested read: Keep calm and invest on

1 - Increasing your SIP amount

As your income increases every year, you can step up your SIP amount in tandem. In effect, you have to step up your SIP once a year. A slight increase can produce a significantly larger corpus. Here’s an illustration:

Suppose you invest Rs 10,000 every month at a rate of return of 12 per cent for 20 years, you’ll build Rs 92 lakh. Pretty cool, right?

Now it’s Step-Up SIP’s turn. If you increase your SIP amount by even 5 per cent every year, you make a fortune of Rs 1.27 crore!

According to the framework, that’s all you have to do.

Suggested read: What is step-up SIP?

Want help managing your mutual fund investments?

Picking the right funds is just half the battle. If emotions derail your decisions, you could undo all your progress.

If you need help building or managing your portfolio, Value Research Fund Advisor can guide you with personalised recommendations and help you stay on track.

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Also read: My junior colleague is richer than my manager. Here's how.