7 Step Guide To Picking Mutual Funds For Investing In India

Gone are the days when investors used to blindly stick to the traditional investment instruments such as FDs, PPFs, NPS, etc for achieving their life goals. With these age-old investment avenues consistently depicting a history of clocking suboptimal returns over the decades, it becomes even more imperative to break away from the tradition of solely relying on such investment tools and explore the immense scope of wealth creation which mutual funds hold. This holds true especially for millennials, given that they have age on their side and are certainly more financially aware and keen to unlock as well as understand the potential of mutual funds and how they can anchor one¡¯s journey of achieving various crucial financial goals in life. So, if you are amongst those contemplating investments in mutual funds, it would be prudent to follow these 7 steps to align your financial goals with the right mutual funds and generate optimal returns from them:

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1. Identify crucial financial goals

The first step to be taken towards the journey of investing your hard earned money in mutual funds is by identifying your crucial financial goals. Investments should always be tied to particular financial goals set in life. Before investing, individuals must be clear regarding the financial goals for which they intend to invest. An investment plan built in the absence of an earmarked goal leads to erratic decision making and suboptimal investments. Not only does the list of financial goals and their order of priority would in all likelihood vary for each one of us, depending upon key factors such as age, income and cashflow, number of dependents etc. but even each of the goals themself require a different approach towards investment planning depending on the linked investment horizon and risk appetite. And when you tie and earmark your investments to separate financial goals, doing so provides a direction to your portfolio creation and maximizes the potential returns from the chosen funds.

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2. Estimate the investment horizon and target corpus

Your investment horizon depends upon your financial goals that are tied to your investment plans. A long term goal such as child¡¯s marriage or your own retirement which involves a longer investment horizon of even beyond a decade or more, would best be achieved through majority investment in equity mutual funds, since equities have consistently proven to yield higher returns than all other alternatives such as PPF for long term investments. Whereas, if your goal is a short term one requiring an investment horizon of just 1-2 years, debt funds can be a suitable instrument, as these involve low risk and offer good returns for lower investment periods. Additionally, make sure your financial position allows you to comfortably invest for the required investment horizon and doesn¡¯t drain you financially.

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3. Assess your risk appetite

Your appetite/ability to take risks is amongst the key anchors that impact your investment decisions to a great extent. Risk appetite is primarily determined on the basis of your stability of income, preferred degree of liquidity, and the investment horizon to be tied to the set financial goals. All these parameters determine whether you are risk averse or a risk taker, and also the degree of risk-low, moderate or high. Based on the identified risk appetite present at the time of investment planning, the investment options are assessed and the ones that are closest to enabling you to timely achieve your goals, should be chosen. For instance, someone aiming to invest for a long term goal such as owning a house after 10 years, the chosen investment avenue would vary as per their risk appetite. A risk averse investor may prefer holding a balanced portfolio involving a mix of both debt and equity funds, whereas, those who have a moderate to high risk appetite for the same goals and horizon would consider opting for investment entirely in equity mutual funds, since equities have consistently proven to be the best avenues for long term goals, providing better returns than other alternative options. Moreover, given that different mutual fund categories are aimed and suitable for different levels of risk appetite, it becomes imperative to ensure identification of your risk appetite while selecting your mutual funds.

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4. Understand the 2 broad categories of mutual funds - Debt and equity

The two popular categories of mutual funds that investors must be clear about before stepping into the world of mutual funds, are debt and equity. Debt mutual funds invest in fixed income instruments like government bonds, treasury bills, corporate bonds, non-convertible debentures etc. These are primarily meant for risk averse/ low risk appetite investors who prefer stability and are content with moderate returns for their investment horizon of short to medium term.

On the other hand, equity mutual funds primarily invest in equity and equity linked instruments. This category of mutual funds involve a higher degree of risk and volatility, especially during the short term, due to their sensitivity towards economic fluctuations and involvement in stocks. However, at the same time, they not only hold the potential of high returns but have also displayed through their past performances that they have consistently beaten both inflation and returns of other asset classes by a wide margin over the long investment horizon.

Hence, equities come out as the ideal choice of investment for long term goals spanning over 5 years and above, and to further assist investors for diversification, equity mutual funds involve different categories such as large cap,small cap, flexi cap, mid cap funds etc, each of which involves different returns¡¯ potential and risk.

Investors can even enjoy a balance of both equity and debt in their portfolio through investment in another category of mutual funds, i.e. hybrid mutual funds. These funds invest in both debt and equity for a balanced portfolio, and thus work well for investors who are apprehensive towards stepping into an entirely equity portfolio, but wish to avail the benefits of potentially high returns through equity component along with possessing the capital protection and stability through debt investments.

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5. Ensure that fund¡¯s investment objectives and strategies match your goal plan

Once you are clear whether to go for equities, debt or a mix of both in your mutual fund portfolio, it becomes both prudent and imperative to check the investment objective and strategies of the funds falling into that category. Going through the mutual fund¡¯s objective and investment strategy before investing would assist in understanding whether it would match your risk appetite, financial goals and adequately enable you to timely achieve the goal through expected returns.

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6. Check the fund's past performance

Another key parameter to check before finalizing any mutual fund, is it¡¯s past performance and how it fared against its peer funds and benchmark indices over different time periods. Checking the past performances is a step that helps to understand whether the chosen fund was able to deal with different economic ups and downs of the past and how it performed when compared to peer funds and the benchmark index. However, remember that the past performances of a fund are just indicators of the potential that they hold, and they do not guarantee the same performance in the future.

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7. Factor in the fund's expense ratio

Simply put, expense ratio of a fund refers to the per unit cost incurred on managing that mutual fund scheme. It is calculated by dividing annual operating expenses (as percentage) with average daily net assets of the fund. As these operating expenses are met from assets managed by the fund, a lower expense ratio would imply that a higher part of your money would remain invested in the fund for availing the benefit of future compounding and growth.

For fetching higher returns on their investment, investors should prefer direct plans of mutual funds over the regular ones, as the expense ratio of the former is usually a notch lower than the regular plans. Hence, presence of a lower expense ratio in case of direct plans is what leads them to generate higher returns. Although the degree of outperformance in returns may seem to be marginal in the initial years, the difference holds the potential to become substantial over the long run, thanks to the immense power of compounding.

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