Investing in mutual funds comes with a lot of benefits. Mutual funds allow the investors to diversify their investment at a substantially lesser cost as compared to an individual investment. If you take the time to study the track record of a high-rated mutual fund, you’d notice that their CAGR outperforms other asset classes by quite a margin.
However, mutual fund investment, much like any other investment comes with its fair share of risks. If you are new to the market, there are some DOs and DON’Ts that you must know to avoid making mistakes and regretting them later on.
Many early-stage investors who have just migrated to SIP from a guaranteed return asset like fixed deposits and PPF often lack an understanding of how the mutual funds work. One needs to understand that, unlike FDs, mutual funds are non-linear. Mutual fund investments can sometimes lead to negative or no returns (especially during the initial period). However, the picture may change entirely within a few years, thanks to compounding. However, if you want to fully utilise the potential of mutual funds, you need to exercise patience, especially when you’re in it for the long run.
Set realistic targets
The performance of mutual funds depends upon the performance of the market. If the market is rising, the mutual funds can even deliver 100 per cent returns in some years. However, on average, they deliver around 12 per cent to 15 per cent returns for 5 to 8 years. The problem though is that this period isn’t fixed. If the market performs poorly due to some economic crisis, you may have to wait a little longer. Unless you’re willing to trudge through the valleys, you wouldn’t be able to make money from mutual funds.
Do your research
You should never invest in mutual funds based on hype. Always do your research and if you find it difficult to understand, hire a financial advisor to help you out. They may charge somewhere between 0.3 per cent and 0.8 per cent of what you make from the market. However, it’ll help you avoid a lot of obstacles that can cause you to incur losses. While researching, you should study the funds’ as well as fund managers’ track records, past returns, comparison with a benchmark, etc.
Invest via SIP
Systematic investment planning (SIP) is a great way to invest in mutual funds, especially for amateur investors. If you have just started and don’t want to take any risks, you can start as low as Rs 100. It also inculcates the habit of forced savings as you need to set some amount aside for SIPs.
Gauge your risk-bearing ability before investing
Depending upon your risk appetite, you can invest in large-caps, small-caps, and mid-caps. The large-cap has the lowest risk factor associated with it but offers lower returns. Mid-caps and small-caps have a higher risk associated with them but also offer higher returns. The smartest way to invest is to diversify your portfolio across these three classes. If you have a high-risk appetite, you can put more of your investment in small-caps and mid-caps. However, if you are risk-averse, you can put more of your investment in large-caps.
Now that we’ve understood the DOs, let us take a look at some of the DON’Ts.
Don’t invest where your friends or colleagues do. Find your own path!
Different people have different goals. While one person may want to invest for their child’s education, another may want to build a retirement corpus. Just because your friend invested in small-caps doesn’t mean that you should too. While you can do so by all means, your investment decision should be driven by your own financial needs.
Don’t focus too much on short-term performance
There have been cases when the funds witnessed a fall of 60 per cent and more! However, once the market gets stabilised, they climbed back and give tremendous returns. However, for the faint of heart, a fall of 60 per cent would mean a return to FDs as investments. Many investors tend to bow out under such scenarios, only to regret their decision later. So even though it is important to take a fund’s performance into account, focussing on the short-term will prevent you from seeing the bigger picture.
Don’t invest in too many funds
A typical mutual fund invests in 50 to 75 companies. It means that when you invest in a mutual fund, you are indirectly investing in all those companies. This helps to reduce the overall risk factor as losses in some stocks will be compensated by gains in others. However, if you invest in too many mutual funds, you wouldn’t be able to benefit from diversification as you’ll be investing in the same companies.
Let's understand this better. According to SEBI, the top 100 companies in the market are called large-caps. It means you have a limited number of options and if you invest in too many large-cap funds, you’ll certainly suffer from duplication. The chances of duplication, however, are lower for mid-cap/small-cap funds as their numbers are significantly higher. As a thumb rule though, it is best to not invest in too many mutual funds.
Hopefully, these DOs and DON’Ts will help you invest safely and effectively.
The author of the article is Rachit Chawla, CEO & Founder of Finway FSC