When investors want to know which fund to invest in, they tend to ask the obvious question, 'Which fund should I invest in?' As an answer, they are looking for the name of the one fund that is 'the best one', according to some nebulous definition of best that they have in their minds. But actually, it's the wrong question, or at least, that's the wrong question to start with. If you start with that question and expect an answer in those terms then there's practically no chance of getting the right answer.
Actually, the right question is 'What type of fund should I invest in'? Choosing the right fund is not a bottom-up activity but a top-down one. The reason becomes self-evident when you pause for a moment and think about the original question, 'What fund should I invest in'? The most important word in that sentence is not 'fund' but 'I'. There are many, many funds that are good enough to invest in. The point is who is investing?
Depending on your circumstances, your financial goals, the time-horizon of your investments, different types of funds will be suitable. Only after the type of fund is defined does the question of which specific fund come up. There's an old joke that if there is a race between five horses and five humans, then there's very little point in trying to figure out which human is the fastest. The choice of fund category is a little bit like that.
For example, suppose you have just sold some real estate and have a large sum of money that you don't need for about a year. Having decided to park the money in a mutual fund for the period you ask someone which is the best fund around without defining your actual need. You are suggested a good mid-cap equity fund which has a five-star rating from Value Research, into which you promptly invest the entire sum. A year down the line, the stock markets remain shaky and your treasure shrinks by perhaps 10 or 20 per cent. Did you choose a bad fund? No, the fund you chose was fine. It's just that the type of fund chosen was utterly unsuitable for the purpose. For a predictable time horizon of one year, an ultra short-term debt fund would have provided a reasonable return with negligible risk.
Conversely, suppose you are putting aside a certain sum of money from your monthly income for long-term savings, which you may not need at least for a decade or more. In such a case, choosing anything but an equity fund is pointless. The period is long enough for the volatility of the equity markets to be damped out. Since you will be investing gradually in a monthly SIP, you will be able to earn returns that are actually better than the overall gains of the equity markets. However, for such a purpose, a fixed income fund would be most unsuitable. In a high inflation environment like India, fixed income rarely beats inflation and your money effectively becomes less over the years. Any equity fund, even a bad one, would be better than keeping the money in a fixed-income fund or a bank deposit.
This article first appeared in July 2013.