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mutual fund proven investment formula

World of Mutual Funds – The Proven Investment Formula

Are you planning for your child’s wedding or deciding on your new house?

Do the thought of funds daunt you?

Are you caught up between trying to earn more and trying to save more?

Unfortunately, these two can be balanced only to a certain extent. Anything beyond that will be suffocating your life. But, there is a way around this.

Have you ever thought about making your savings earn for you?

And by “making your savings earn for you” I do not mean your bank interest or interest from RDs and FDs.

They barely beat inflation, at best. If anything, they can only help sustain the value of your savings against inflation. But, if you want your savings to earn beyond inflation…

Mutual funds could be your answer.

In this article, you will learn about Mutual Fund investments and the proven investment formula to get the best out of your investments.

Table of Contents

What is best about Mutual Fund investment?

Being the brain-child of Wall Street, mutual funds offer hassle-free investment opportunities that can cater to a wide range of risk profiles.

Understanding the nuances of investing in mutual funds requires hard work.

For an absolute beginner, a mutual fund scheme is an investment instrument that invests a large pool of money, collected from investors, in a range of stocks. This range of stocks is chosen by the mutual fund scheme’s fund manager.

But with meticulous planning, the rewards from mutual funds will far outweigh the required efforts. Not to mention the steep learning curve in the initial months that will help you in your investment journey for decades to come.

To know more about mutual funds and its different flavours, do read the following section on how these can be suited for individual investment requirements.

Are mutual fund investments the one stop shop?

The short answer is yes.

If you have a clearly set your financial goals, you will barely need to look beyond mutual fund investments.

Imagine you are unwell and need medical advice.

Which doctor would you resort to?

Medical science these days has numerous specialties and for the best advice you need to visit the doctor who has specialized in the area where you need consultation / advice. This increases your chance of recovery. The story is no different in mutual funds.

There are varieties of schemes and each of it has a different blend of risk, safety and returns. Based on individual requirements and goals, investing in mutual funds through professional guidance can yield good returns.

An investor can choose the appropriate type of mutual fund to invest based on their risk tolerance profile. They can be classified as,

    1. Risk Savvy Investor-High tolerance
    2. Risk Neutral Investor-Medium tolerance
    3. Risk-Averse Investor-Low/No Risk tolerance

Even though there are other factors to consider in selecting a fund, choosing based on risk tolerance is a good place to start for a first-time investor.

Let’s see what these 3 categories mean and what kind of mutual fund scheme each of them can choose to invest their money in.

Risk savvy investors

These are the investors with high-risk tolerance and capable of enduring the equity market volatility.

Investors who are risk tolerant and expect higher returns can resort to equity mutual funds. These investments are preferred by younger generations who are aggressive and have long term goals.

Due to volatile nature of the equity market these mutual funds carry a very high rate of risk. The high risk is compensated by way of high returns to the investor.

Based on the market capitalization, equity mutual funds investment are of 3 types:

  • Large-cap funds
  • Midcap funds
  • Small-cap funds

Another variation is the index funds where the funds mirror the returns of a specific stock market index.For example: Sensex 500, Nifty 50, Nifty Midcap 100, etc.

For a long-term investor, even the index has proven to be a high return investment option.

The image below shows the growth of ₹10,000 invested in different investment instruments over the past 40 years (1979-2019).

Now, this is only the performance of Sensex.

If the same investment was made in an actively managed mutual fund having high-quality stocks, it would have given even better returns.

But returns are not the only thing that investors care about while investing in mutual fund schemes. It also the tax liability that could come along with it.

Is Taxation on Mutual Fund Return A Worry?

The only reason, other than misunderstood risk, investors look away from equity mutual funds is to “avoid” taxation.

Should it be a worry?

Let’s find out.

  • Dividends Tax in the hands of investor

  • The budget for the financial year 2020-21 made dividends taxable in the hands of investors. It was previously paid by the AMCs (Asset Management Companies) not the investor.

    However, it is not a concern for investors with a long-term investment plan. That is, investors who opt for the “Growth option” in their mutual fund investment will not be liable to any dividend taxation.

    If you are an equity mutual fund investor, the formula is to invest long-term and choose the Growth Option so you can avoid tax on dividends.

  • LTCG Tax in the hands of investor

  • On the other hand, investors will have to pay the Long Term Capital Gains (LTCG) Tax on the sale/redemption of equity mutual fund units.

    The Long Term Capital Gains tax is levied only on the capital gains and not on the invested capital. Also, the long-term capital gains tax is applicable only if the equity units are held for more than 36 months.

    It may sound like a trade-off compared to, say an endowment insurance policy investment. They are all completely tax-free. But in reality, there is not any trade-off.

    LTCG tax is only applicable to the capital gain over and above ₹1 lakh in a financial year. And it is levied at a rate of only 10%; a lesser tax rate than any other asset class under LTCG.

    Even with LTCG @ 10%, Equity Mutual Fund investment has proven its potential to deliver higher returns in the interest of the investor.

    Being taxpayer-friendly, equity mutual funds attract risk-tolerant individuals as an efficient long term investment formula since capital gains are not taxed.

    If you are looking at funding your ward’s higher education after their graduation or planning for their wedding in another 5-7 years, equity mutual fund is your best shot.

    In addition to these, if you are looking for tax savings, then you may consider mutual fund ELSS (Equity-Linked Savings Scheme) schemes.

    It entails the investor a tax benefit of up to ₹1 lac under section 80C of the Income Tax Act, in a financial year.

Risk averse investors

If you are not a “Risk Savvy Investor” as seen above, you may be on the opposite extreme.

You may be an investor drawing close to your retirement finish line, where you don’t have enough time to take calculated investment risks as with equity mutual funds.

Or you maybe someone with capital preservation as your priority and capital growth can take a back seat.

If you identify yourself with either of these, mutual funds have an answer for you too.

Debt mutual fund schemes as an investment helps you to park your money safely. Debt mutual funds carry a lower earning potential but are rated high on safety when compared to equity funds.

Do debt funds and FD look the same?

Well, they are not.

FD’s carry a lock-in period and can make the tax implications higher.

The tax efficiency of debt mutual funds makes the investment scale tilt in its favour, since the tax levied on capital gains by debt funds is lower than that of FDs.

Do debt funds and FD look the same?

Well, they are not.

FD’s carry a lock in period and can make the tax implications higher.

The tax efficiency of debt mutual funds makes the investment scale tilt in its favour, since the tax levied on capital gains by debt funds on capital gains is lower than that of FDs.

Based on time horizon, the debt oriented mutual funds can be:

  • Liquid funds and ultra-short funds
  • These are ideal to meet very short term goals with a time horizon of 0-1 year.

  • Short term debt funds
  • Ideal to meet short term goals with a time horizon of 1-3 years.

  • Accrual based Income Funds
  • They assure regular fixed income generally preferred during retirement.

  • Fixed Maturity Plans (FMP)
  • It is a close-ended fund, which is the mutual fund industry’s version of a fixed deposit. These plans invest in debt instruments issued by corporates whose maturity matches the maturity of the FMP.

    On a side note: Debt mutual funds are not limited to only the risk-averse investors.

    If you are a first-time investor and have just started earning, you can ease into the equity mutual funds by starting with a debt mutual fund scheme. It will act as a sandbox for the first time investors to get acclimatized to the mutual fund investment realm.

3. Risk neutral investors

And finally, we have the risk-neutral investors.

A risk-neutral investor is someone whose priority is capital preservation but is willing to give room for capital growth when there is an opportunity.

Luckily, mutual funds give opportunities and options to this kind of investor, too.

Do you feel you are balanced and risk-neutral?

Then your best resort is hybrid/balanced funds.

Choosing between debt and equity is arduous and might not pass the test of time, considering returns and goal achievement. Balanced funds invest in a combination of both equity and debt-based on investor’s age and market conditions.

Based on the strategy and objectives, hybrid funds come in 3 flavours:

  • Monthly Income plans:
  • It allocates funds in the ratio of 80 and 20 between debt and equity

  • Asset Allocation Funds:
  • Balanced funds that combine more than one asset class into a single portfolio and help diversify the investments.

  • Arbitrage Funds:
  • It is primarily a debt fund, but simultaneously trades stock when there is a growth opportunity (undervalued stocks) identified by the fund manager.

Hybrid funds are not only for the risk-neutral investors. They also act as an excellent mutual fund investment for those in the transition phase going from a risk-averse investor to a risk savvy investor.

For example: You may be a young investor who has been investing in debt mutual funds for a year or two now. Even though you have enough understanding of mutual fund investments, you still may not have gotten used to equity market volatility.

In such a case, diving headfirst into the equity market could cause adverse effects in your portfolio. Instead, you can test the waters with a balanced fund that has ~60% equity exposure. Later on you can increase the equity proportion in a pure equity oriented mutual fund scheme.

Hybrid funds are perfect investment instruments for investors in transition with their risk tolerance.

Conclusion

Mutual fund investment is not just about money. It is a planned money-making exercise.

It is the nexus between a smart investor and a good life.

Understanding the risk and reward factors of the funds is key to successful investing. While mutual funds are not an overnight get rich phenomenon—with channelized efforts and professional guidance—you will find that the path of mutual funds is easy to surf through.

If you are not sure where to start, we are here to help you.

Book your FREE 30 Minute Discussion with a Certified Financial Planner today!

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