Five things you need to know before investing in mutual funds

Mutual fund investments are popular as they are a dependable choice for investors who want to build wealth, while limiting risk with a diverse portfolio. However, making a strategic investment requires one to understand the fundamental principles that influence the investment outcome. This article talks about five vital points to consider before investing in mutual funds.

1. Understanding the different types of mutual funds

Mutual funds are designed to cater to various financial objectives and risk levels. Thus, one must understand the different types of mutual funds.

A. Equity funds:

Through equity funds you can invest in stocks with higher return potential combined with increased risk. These funds are better suited for long-term investment goals and cater to people capable of handling market volatility. The Securities and Exchange Board of India (SEBI) has a total of eleven categories under equity funds.

B. Debt funds:

These funds focus on bonds, government securities, and other fixed-income assets. Debt funds are relatively stable than equity funds and are suitable for short to medium-term goals. SEBI has sixteen categories of debt funds.

C. Hybrid funds:

Hybrid funds provide you with a balanced approach to risk and returns, combining equity and debt investments and giving you steady growth. There are seven categories of hybrid funds schemes by SEBI.

Choosing the right type of mutual funds allows you to allocate investments according to your financial goals and risk profile.

2. Assessing personal risk tolerance

Each type of mutual fund has its own risk factors, and it is crucial for you to understand your risk tolerance while investing in mutual funds. You might want to focus on elements like investment horizon, income level, and financial goals.

If you have a high-risk tolerance or a longer investment horizon, you might be attracted to equity funds or aggressive hybrid funds. People who might be closer to retirement have a lower risk tolerance and they may prefer to invest in debt or balanced funds.

3. Examining expense ratios and associated fees

Mutual funds charge an annual management fee called the expense ratio. It can range from 0.5% to 2.5% of the investment. The fee might appear minimal but in the long-term, a high expense ratio can eat into the returns significantly.

Actively managed funds that try to outperform the market usually have higher expense ratios compared to passively managed funds. Before investing, you should compare expense ratios to ensure you get optimal value.

4. Evaluating the fund’s historical performance

While the past performance of a mutual fund offers insights into how it might perform in different market conditions, it should not be the sole reason for you to invest. Historic performance cannot accurately predict future returns.

You must first review a funds performance over the past 5 to 10 years to evaluate consistency and its ability to meet or exceed benchmarks. You might also want to factor in the fund manager’s experience and strategy as it is a factor that helps design the future outcomes. The mutual funds that show stable, incremental growth rather than sharp highs are lows are the most reliable.

5. The two modes of investment

Mutual funds offer flexibility in investment modes, catering to short-term and long-term goals. Understanding this will allow you to make the choice that aligns with your objectives.

A. Lumpsum investment:

This mode allows you to invest a substantial amount in one go. It is recommended for investors with a larger disposable amount seeking to maximise returns over the long term. Lumpsum investments tend to be more effective when the market is at a low, enabling you to benefit from a recovering market.

B. Systematic Investment Plan (SIP):

It lets you invest an amount on a regular basis in your chosen mutual fund scheme. With the feature of rupee-cost averaging, SIPs help reduce the impact of volatile markets. By investing small amounts consistently, you can build wealth over the long term with reduced risk from market timing.

Choosing the appropriate investment mode helps you stay aligned with your financial strategy, enabling you to manage risk while maximising returns.

Ending note

Mutual funds are an effective and efficient way to create wealth and achieve diverse financial objectives along the way with careful planning. By understanding your risk tolerance, selecting the appropriate fund type, reviewing expenses, and choosing the right investment mode, you will be able to make well-informed decisions. This will help you optimise investment returns and enhance the overall experience of mutual fund investing.