Beginner's guide to mutual funds

Here's everything a first time mutual fund investor needs to know and do

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Mutual Funds are a well-diversified, low-cost and tax-efficient way of making your savings grow. They are an ideal investment vehicle for those who do not have the expertise to invest directly in stocks. You simply invest in a fund, and the fund manager will do the job of picking the stocks that he thinks will yield good returns.

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Despite their simplicity and suitability for small investors, mutual funds are not a preferred investment vehicle for the vast majority of Indian investors who are either not aware of them or find them too complex to understand.

If you happen to be one of them, here's a primer that should help you step into the world of mutual funds with ease. It summarizes the key steps in your mutual fund investing journey and explains all you need to know.

  1. Getting started:  There are a few one-time pre-requisites that you must complete before you can invest in a mutual fund. You need to have a bank account and you must be KYC (know your customer) compliant. Simply put, KYC is the process of verifying the identity of an investor. You can check your KYC status on this link. If you are yet to register for your KYC, you can apply for it with a Registrar and Transfer agent. You can apply for a KYC with a Registrar and Transfer agent (CAMS/KARVY) or directly through a mutual fund house. Self-attested copies of proof of address, proof of identity and recent passport size photographs are required. For small investors, the facility of e-KYC is also available now in which you do not need to submit any physical forms. Lastly, you need to have a permanent account number (PAN) and Aadhaar number.
  2. Choosing funds: Mutual funds are meant to simplify the job of investing for you. But ironically, the task of choosing the right funds can become overwhelming, given that you are faced with more than 2,500 fund schemes to choose from. Here are the decision points you'll be confronted with and here’s how you can make the right choices with ease.
    1. Debt or equity? Referred to as the asset allocation decision, this is basically where you decide whether and how much should you invest in fixed income yielding securities versus equity shares. Both are meant to fulfil different needs. Debt mutual funds offer steadier but lower returns. Given their low risk-low return profile, they are a suitable choice to meet short-term goals where capital preservation assumes precedence over return potential. Read our story 'How do debt mutual funds work'
      On the other hand, as the name suggests, equity mutual funds invest in shares which can earn far higher returns but can also fluctuate much more in the short term. They are suitable for time horizons of five years or more. The chances of incurring losses from equity investments fall drastically over longer investment horizons. And coupled with their superior return potential, they are an ideal choice to build meaningful wealth over long-term. Read our story 'How do equity mutual funds work?'
      If you are a first-time investor looking to invest in equity, aggressive hybrid (balanced) funds could be a suitable option for you. These funds invest between 65% to 80% of your money in equity and the rest in debt. With this combination, you get a good flavour of equity investing even as the debt portion brings a bit of stability.
      In summary, a debt fund is a suitable choice to invest the money you have earmarked to buy a car next year. On the other hand, equity and balanced funds will be a good way to plan for retirement.
    2. Which funds? Once you have decided on your debt-equity allocation, the next step is to pick the specific fund(s) within the debt or equity categories. Do not randomly pick mutual funds or blindly rely on the advice of a relative or a friend. You should opt for funds that have performed well consistently over the long-term instead of the season's chartbusters. The list of 4 or 5 star rated funds by Value Research can greatly simplify your job. These ratings are based on funds' long-term risk-adjusted returns and therefore, reward funds that have a proven track record of performance. Check out the list of 4 and 5 star rated funds here: Top rated funds.
    3. How many? Even by investing in a single fund, your portfolio gets diversified across 40-50 stocks. Two or three funds from different fund houses are quite enough to provide adequate diversification. With a larger number of funds you may just end up replicating your existing holdings.
    4. Direct plan or Regular plan? Every mutual fund now offers a direct plan and a regular plan. They are the same except that a direct plan charges lower annual expenses (lower by around 0.75%-1% per annum in case of equity funds) because it does not pay the distributor fee or commission. This is because in case of this type of plan, you have invested the money yourself, without going through a broker or agent. Whilst Direct Plan will save you money, you'll have to do everything yourself, and being a 'do-it-yourself'  investor requires active tracking, rebalancing, switching funds, etc. which can be daunting for a beginner. You may want to instead go through a distributor initially and invest in regular plans. Later on, once you’ve become more knowledgeable and confident, you can think of switching to direct plans.
    5. Growth option or Dividend option? If you don't have a specific requirement to get part of your money returned in the form of dividends (as and when they are declared by the fund house), it is best to go for the growth option. This will ensure that your fund's returns make the most of compounding. Read this article to know about why dividend is not something 'extra' that you get and how the magic of compounding works to your advantage with the growth option.
  3. Buying funds: Now that we are past the stage of choosing funds, we are ready to go ahead and buy them. You can either buy funds directly from a fund house or through an intermediary.
    For investing directly, you'll have to submit filled forms, cheques, etc. at investor service centers of the mutual fund houses or registrars, who have their branch networks across many cities. Or more conveniently, you also have the option of investing online at the websites of the mutual fund houses.
    In case you prefer to invest through an intermediary, there is a wide variety of them available, including banks, individual financial advisors, distribution companies, online portals, and brokerages.
    At this stage, you'll need to ponder over how much to invest and at what frequency. Here, you broadly have two options - lump sum investment or Systematic Investment Plans (SIP). Lump sum is, of course, investing the entire money that you want to invest at one go. SIP, on the other hand, means investing a fixed amount at a fixed frequency (generally monthly). For instance, if you have Rs 1 lakh to invest, you may invest the entire amount in lump sum or you may create a monthly SIP with each installment of Rs 10,000 over a 10-month period. Which one is better? Well, for debt funds, you may invest in lump sum but for equity or balanced funds, we strongly recommend you create an SIP spread across a certain number of months. Read our story 'Are SIPs always better than lump sum?' to know why.
  4. Monitoring your investments: You should keep a track of how well your investments are performing. But don't overdo it. Given the ubiquity of modern technology, you will constantly get updates about the ups and downs of the market. Do not be swayed by them. Reviewing your investments once a while is all you need to do. This website provides the Portfolio Manager tool for free, which is a one-stop tool for analyzing every detail of your portfolio. Click here to know how you can easily put your investment details in the Portfolio Manager tool and to get a detailed, yet easy-to-digest analytics on your investments.
  5. How and when to sell: There are broadly two reasons why you should consider selling your fund - 1) It has become a poor performer; or 2) You need the money to meet the financial goal(s) for which you were investing, in the first place. Let's look at both of them one by one.
    1. Poor performance: If the fund’s performance has been consistently dipping, compared to the peer group and benchmark, you should consider carefully whether or not it should be part of your portfolio. However, don’t let a single month of bad performance change your mind. You need to take a longer-term view on this. A quick and convenient way is to keep an eye on the fund's rating. In case its rating drops to one or two and remains there for a few months, you can consider selling it and looking for a better option.
    2. Meeting your financial goal: In case of equity funds, you should withdraw systematically (remember SIP?). Therefore, as your planned goal nears, exit your equity funds over 2-3 years and move your money into debt funds. This gradual withdrawal is important to avoid getting adversely impacted by any sharp declines in equity markets right at the last minute. In case of debt funds, however, it is fine to withdraw your money at one go.

Lastly, you should keep the tax implications in mind while selling your funds.

Read 'How are mutual funds taxed?' to get additional perspective on selling funds and their corresponding tax implications.

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