When you invest in a mutual fund, your money is managed by fund managers who are professional money managers. This means you transfer the risk of finding the right time to buy to a professional. At a time when there is economic gloom all around and stock markets behave erratically, it is not easy to find the right instrument for parking the investible surplus.
What can you do?
First, make a calendar of big-ticket financial events in the near future (This could be a horizon of two to five years). This could include a wedding, or vacation, or school tuition, or your own running expenses, since these will help you figure how much money you need at what time. Invest accordingly.
Here are a few pointers to investing wisely in mutual funds:
Short-term: After ensuring enough money as contingency, make sure your next lot of money gives more than capital protection. A short-term horizon could be one to three years. Go for a debt mutual fund scheme that doesn’t take too large credit calls. Some MFs will only invest your money in government bonds, certificates of deposit of companies or public sector company bonds that are guaranteed by the government. These are safer bets.
Duration risk: Don’t take too much duration risk, as this will kill your principal. Especially in fixed income, too much of a duration risk could kill principal. In a mutual fund, liquid funds provide lower duration risk as you can pull out your money at short notice. Currently, short-term funds are the flavor of investors. Go for a duration of 12-18 months, instead of 4-5 years. That is a reasonable number, as the probability of getting a negative return is lower as your principal is safe.
Post-tax returns: Make sure your post-tax returns are protected. In fact, you should try and maximize your post-tax returns. Once the Rs 10,000 mark is crossed in your savings account, go in for a mutual fund. Dividends paid by mutual funds are tax free for equity schemes. There are no tax benefits for debt funds or liquid funds.
Ensure liquidity: There are times that we need money at short notices, especially medical emergencies. In such cases, you should be able to withdraw your money at short notice. The problem with equity markets is that you don’t know what you will be holding when you actually need money. Fixed deposits are one option, of course, but you can also go for a liquid fund, that also gives you good tax arbitrage. You may be advised to go in for a fixed maturity plan. But these plans come with a lock-in and you are not able to withdraw funds when needed. If you do, you lose. In a liquid fund, at least your capital will be there. Also, you can’t borrow against your FMP since lenders are also de facto locked in for the period of the plan.
Equity funds: This is an option only if you have surplus money and the time horizon is at least 3 to 5 years. This is because you don’t know when you will make money. Only allocate money that you will not need in a hurry. Always go for a systematic investment plan (SIP) instead of trying to buy when market is low and sell when it is high. If you are going for an equity fund, make sure to diversify across 3-4 funds, particularly to avoid so-called fund manager risk. You can buy monthly income funds, which invest 80 per cent in debt or fixed income securities and 20 per cent in equity markets. If the time horizon is between three to five years, you could invest in a balanced fund or a dividend yield fund.