When you are a beginner looking to invest in mutual funds, there might be questions in your mind like – what is a mutual fund, and what purpose does it serve? Well, having a clear understanding of each of its aspects is very important. A mutual fund is a smart way to pool your money and invest in various assets.
This approach allows individuals to benefit from professionally managed portfolios regardless of their investment knowledge. As you keep reading this article, you will know the concept of mutual funds, the types of mutual funds, and their purpose in simplifying investment for everyone.
What is a Mutual Fund?
Let’s start with understanding what a mutual fund is. A mutual fund functions as a collective investment vehicle, bringing together funds from numerous investors to create a diversified portfolio of securities. These securities include stocks, bonds, and short-term debt instruments. The entirety of these holdings constitutes the mutual fund’s portfolio.
When investors participate, they purchase shares, symbolising their ownership stake in the fund. Each share reflects the investor’s proportional ownership and entitlement to the income generated by the fund. This pooled approach allows individual investors to benefit from professional fund management, diversification, and the potential returns generated by various financial instruments. Mutual funds provide an accessible and collaborative means for individuals to engage in the financial markets and pursue investment goals.
Why Are Mutual Funds Preferred by Most People?
Here are some of the reasons people prefer mutual funds.
- Professional Management:
Mutual funds are like having a financial expert on your side. Fund managers take care of research, choosing the best investments, and monitoring their performance. It means you can benefit from their expertise without being an expert yourself.
- Diversification:
“Don’t put all your eggs in one basket” is a golden rule of investing. Mutual funds follow this by investing in various companies and industries. If one company faces troubles, your overall risk is lower because your money is spread out.
- Affordability:
Mutual funds make investing accessible. You don’t need a huge amount to start – they set reasonable minimum investment amounts, making it easier for anyone to get started.
- Liquidity:
Need your money? Mutual funds let you cash out your shares anytime. You get the current value of your investment plus any small fees, if there are any. This flexibility ensures your money is kept from being tied up when needed.
Types of Mutual Funds
There are many types of Mutual funds categorised into four primary types, each boasting distinct attributes and considerations. Here are the key types of mutual funds:
- Money Market Funds:
Representing the low-risk spectrum, money market funds invest judiciously in short-term, high-quality instruments. These financial guardians are legally bound to allocate funds to specific, secure investments from reputable entities such as corporations and government bodies.
- Bond Funds:
These funds embrace a higher-risk landscape driven by the pursuit of elevated returns. Given the diverse nature of bonds, the risks and rewards associated with bond funds exhibit notable variability, akin to a financial rollercoaster ride.
- Stock Funds:
Venturing into the corporate world, stock funds embody dynamism with varied objectives. Growth funds target stocks with the potential for substantial financial gains; income funds prioritise regular dividend-paying stocks; index funds meticulously track market indices; and sector funds specialise in distinct industry segments.
- Target Date Funds:
As strategic financial companions, target date funds curate a diversified portfolio comprising stocks, bonds, and other assets. Uniquely, these funds adapt their asset mix over time, adhering to a predetermined strategy. Tailored for individuals envisioning specific retirement dates, target date funds, also known as lifecycle funds, offer a structured approach to wealth management.
Benefits of Mutual Funds
- Professional Management:
These are managed by financial experts, ensuring sound investment decisions for individuals without extensive financial knowledge.
- Diversification:
These spread risk by investing in various assets, minimising the impact of poor performance in a single investment.
- Dividend Payments:
They offer a regular income stream as investors receive a portion of the fund’s earnings through dividends.
- Capital Gains Distributions:
It provides additional returns by distributing profits when the fund sells securities at a profit.
- Increased Net Asset Value (NAV):
It reflects growing investment value as the fund’s assets increase over time.
- Affordability and Accessibility:
It enables investors to start with modest amounts and increase contributions over time, fostering accessibility.
- Liquidity:
It allows investors to redeem shares anytime, offering flexibility and quick access to invested capital.
- Regulated by Professionals:
Mutual funds operate under financial experts’ strict oversight, ensuring fair and transparent operations for all investors.
Risks of Mutual Funds
- Market Risks:
Market fluctuations influence mutual funds. If the market takes a downturn, the value of your investment may decline.
- Credit Risks:
Investments in mutual funds may include entities facing financial challenges. If these entities default on payments, it can adversely affect your investment.
- Interest Rate Risks:
The fluctuating interest rates, akin to a seesaw, impact bond returns within mutual funds. A rise in interest rates may lead to a decrease in the value of bonds.
- Liquidity Risks:
Liquidity risk occurs when investors can’t easily sell their investments. It can stem from scheme type (e.g., close-ended) or illiquid securities.
What to Consider When Investing in Mutual Funds?
- Fund Performance:
Consider how well the mutual fund has performed in the last 3-5 years compared to its benchmark and category. Check for consistency. If it’s a small-cap fund, compare it against a small-cap benchmark. Benchmark indices set the standard for performance evaluation.
- Net Asset Value (NAV):
NAV is the market value per unit of a mutual fund. High NAV funds may cost more but offer growth. However, a higher NAV can mean quality investments. Don’t decide solely based on NAV; consider other factors like growth opportunities and reliability.
- AMC Performance:
Assess the overall track record of the Asset Management Company (AMC). Investment decisions at the AMC level impact multiple schemes. A strong AMC track record suggests sound decision-making and potential future performance, even if some funds underperform.
- Expense Ratio:
Expense ratios cover fund management costs. Check these fees, usually between 0.5-1.5% -even a small difference in the expense ratio matters.
Conclusion
A mutual fund is a collaborative investment vehicle where investors pool their money, guided by professional fund managers. This collective approach allows individuals, irrespective of their financial expertise, to access diversified portfolios comprising stocks, bonds, or other securities.
Mutual funds come in various types, catering to diverse investor preferences. This investment diversity and professional management make mutual funds an intelligent and accessible choice for new and seasoned investors, boosting wealth growth and financial stability.
