Mutual Funds: What You Need to Know Before Investing?

20 Dec 2022
6 min
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Your financial independence shouldn’t be feared; in fact, it should be embraced. When most people think of investing, they imagine sitting at their desks with a pencil and paper and analysing the details of different investment avenues. But that’s just planning. Real investing is about understanding the risks involved, acting and making decisions. A sound financial plan is a great way to achieve financial security and build wealth over the course of one’s life. However, the process of investing money can be complex and confusing. To that end, we thought we’d answer some common questions about mutual funds. These answers may help you make an informed financial decision so that you don’t spend more time reading financial jargon than contributing towards your goals. Read on to learn more!

What are mutual funds?

A mutual fund is a type of financial instrument in which money from individual participants is pooled together. Companies that meet the requirements to establish mutual funds form Asset Management Companies (AMCs) or Fund Houses. The AMC then pools investor funds, markets mutual funds, manages investments, and facilitates investor transactions. Based on the investment objective, the money collected from mutual fund investors is invested in stocks, bonds, and other financial assets as per the scheme mandate.

Why should you invest in mutual funds?

Disciplined mutual fund investment can help you achieve both short and long-term financial objectives with the following advantages -

1. You Can Start Small

“Every drop counts”. Mutual funds do not require a hefty investment. You may invest as little as Rs. 500 each month in a Systematic Investment Plan (SIP) and steadily raise your commitment over time.

2. Investment Discipline

A Systematic Investment Plan (SIP) is a type of mutual fund investment in which investors make regular, automated contributions periodically. Your money is invested in your chosen fund on a regular basis. This aids in instilling investment discipline in one's life.

 

3. Professional Management

Mutual funds can be beneficial to every investor, particularly retail investors who are unfamiliar with the capital market. This is due to experienced investment teams developing fund strategies, researching investments, making transactions, and monitoring fund performance.

4. Diversification

Mutual funds can invest in a wide range of financial assets, providing investors with a simple option to diversify their portfolios. An investor can have exposure to various stocks by investing in only one fund for as little as INR 500. Diversification reduces the negative impact on the overall portfolio of single financial security. Furthermore, because they invest in a diverse basket of selected securities, mutual funds may generate alpha over the medium to long term.

5. Transparency

You receive regular information on the value of your investment in the form of account statements. Disclosure of the investments made by your scheme in the form of portfolio disclosures reveals the proportion invested in each asset class. The Scheme-related documents also detail each scheme's investment strategy and asset allocation.

6. Regulated

All mutual funds operate within the regulatory framework designed by the Securities and Exchange Board of India to protect investors' interests. SEBI monitors mutual fund operations on a regular basis.

 

How Mutual Funds Work?

Mutual funds are nothing but an exchange of Net Asset Value (NAV). NAV is the price at which transactions like buying and redeeming of mutual fund investments take place. Each investor is given a number of units proportional to their investments and this is based on the NAV. For example, if you invest Rs 1000 in a mutual fund with a NAV of Rs 10, you will receive (1000/10), 100 units of the fund.

Assume a fund house launches a new scheme. Hypothetically, the scheme collects Rs 4 crore from 200 investors who invest Rs 2 lakh each. As a result, the fund issues the units at a NAV of Rs 10, and each investor receives 20,000 units (200000/20). As a result, the fund house will allocate a total of 40 lakh units.

The NAV of the mutual fund, like stock prices, changes daily based on the performance of the assets in which the mutual fund is invested. So, in our example, if the stock price rises, the overall value of the stocks in the portfolio rises, and thus the NAV rises. If the mutual fund's NAV increases to Rs 13, with no change in the number of units in the scheme, the investor's 20000 units, which were previously worth Rs 2 lakh, will now be worth Rs 2.6 lakh (20000 units x Rs 13). This equates to a Rs 60000 profit (Rs 2.6 lakh – Rs 2 lakh).

As previously stated, the daily market value of the mutual fund portfolio is not fixed, so the NAV fluctuates daily, depending on the value of the fund portfolio. As a result, this Rs 60000 gain could alternatively be a loss, depending on how the NAV moves and how the underlying assets perform. Because mutual fund investments are market-linked, the returns are not guaranteed and are also volatile.

How to redeem mutual fund units

Continuing our example, if the NAV rises and an investor decides to redeem his/her units at a NAV of Rs. 13, he/she will earn Rs 60000 in addition to the Rs 200000 originally invested. Such redemption will be subject to exit load, if any, and subject to applicable capital gains tax because mutual funds are subject to both short-term and long-term capital gains tax (STCG and LTCG).

Modes of Investing in Mutual funds

1. Lumpsum 

If you want to invest a substantial amount in a mutual fund at one time, go for lump sum investing. For example, if you have Rs 10 lakh to invest, you may invest the entire amount of Rs 10 lakh at once in a mutual fund of your choice. The number of units you receive is determined by the fund's NAV on that particular day. In the given example, you will receive 1000 units of the fund if the NAV is Rs 100.

2. Systematic Investment Plan (SIP) 

You can also invest small amounts periodically. In the above example, suppose you do not have Rs 10 lakh, but you can commit to an investment of Rs 10000 per month. SIP is one method of doing so. SIP encourages regular investment of fixed amounts monthly, quarterly and so on, depending on your need and the options available with the mutual fund.

As the NAV rises, the value of the units increases and when NAV reduces, the value of the units reduces.’

SIPs can help you build a larger mutual fund investment portfolio over a prolonged period.

 

Risks Involved in Mutual Funds

1. No Guaranteed Returns

Unlike fixed deposit in a bank, mutual fund returns are linked to market returns. Hence, you cannot earn fixed guaranteed returns from your investments in mutual funds.

2. Inflation Risk

An increase in consumer prices would decrease the purchasing power of your investment if inflation rate risk is present.

3. Manager's Risk

The performance of any mutual fund is affected by the manager's experience, knowledge, expertise, and investment procedures/methods in addition to any shortfall in those areas.

4. Market Risk

Every investor has seen that one-line in every marketing stating that mutual funds are subject to market risks. Mutual funds are vulnerable to market risks, which can result in losses for any investor owing to the market's bad performance.

 

Now that you've discovered the advantages and difficulties associated with mutual funds, you may use them to help you be disciplined with your money. Mutual funds may be used to achieve a broad range of life goals by selecting a fund that matches your goals and risk preferences. Investing in mutual funds is not just about timing the market, but rather about choosing the best funds for your goals and risk tolerances. 'Time in the market' beats 'timing the market' every time. Start with small regular investments now.

 

Mutual fund investments are subject to market risks, read all scheme related documents carefully. The information in this document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipients of this material should rely on their investigations and take their own professional advice.

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