Tips for choosing the right mutual fund

Mutual funds offer a variety of options, each with its own benefits and risks. Some focus on stocks, some on bonds, and some are a combination of both. But figuring out which one is right for you can be a difficult task. It's all about understanding your financial goals, how much risk you're okay with, and how long you plan to invest. Let's break it down and find out how to pick the suitable mutual fund for you, step by step.

Table of contents

Factors to consider before selecting mutual fund category
Things to evaluate before choosing a mutual fund
Other factors to consider

Factors to consider before selecting mutual fund category

Based on what types of assets they invest in, mutual funds can be broadly classified as equity, debt, and hybrid funds. Equity funds invest primarily in company stocks. Debt funds invest in bonds and other fixed-income securities. Hybrid funds, meanwhile, invest in both equity and debt. Some hybrid funds are more equity-oriented, some more debt-oriented, and some have an even balance between both. Selecting the right mutual fund category is essential to have a potentially rewarding investing experience. Here are some factors investors should consider when choosing the scheme category:

Investment objectiveThis is your financial goal or the purpose for which you are investing money. This will influence the type of fund that is suitable for you. For example, if you are saving for a holiday that is a few months away, you need a liquid avenue that is relatively safe. A debt mutual fund may be suitable for that. If you are saving for retirement, a home purchase, higher education, or another goal that is several years away and also requires significant wealth accumulation, you may consider equity-oriented funds. Such funds offer good return potential over time but require a long investment horizon to potentially tide over short-term market fluctuations.
Investment horizon Related to the point above, your investment horizon will also influence the mutual fund category that is suitable for you. For short-term investments, debt mutual funds may be suitable as they offer relative stability of capital invested. Within this, for very short-term goals, (less than a year away), liquid funds, overnight funds, or money market funds may be suitable. For medium-term requirements, hybrid mutual funds that balance growth potential with relative stability may be suitable. And long-term investors may consider equity mutual funds.
Risk tolerance: This is how much risk you are able to tolerate. Based on risk tolerance, investors can be broadly classified as:
Other funds: Their low-risk appetite may lead them to prefer debt mutual funds or hybrid funds with a higher allocation to debt securities for relative stability and lower risk compared to equity-oriented funds.
Moderate risk tolerance: Investors with a moderate risk appetite may opt for hybrid funds with a balanced mix of equity and debt to achieve a blend of growth potential and relative stability during uncertain markets.
Aggressive investors: High-risk appetite investors may focus more on equity mutual funds to seek potentially higher returns over the long term with higher associated risk.

Things to evaluate before choosing a mutual fund

Once you have identified your mutual fund categoxry, here are the factors you may consider when choosing a suitable scheme within that category:

1. Investment strategy: Look at the investment strategies that different mutual fund houses follow for the scheme category you are invested in. You can find this information on the asset management company’s website and the Scheme Information Document

2. Risk: Check the risk level of the scheme to ensure it aligns with your risk appetite.

3. Liquidity: Some schemes have a lock-in period, some are closed-end funds that can only be redeemed at maturity. So, if you need access to your funds, make sure to choose an open-ended scheme or one without a lock-in.

4. Fund performance: Look at the historical performance of the scheme. The data will be available if the scheme has been open for a year or more. Do note, however, that past performance may or may not be sustained in the future.

5. Expense ratio: This is the fee charged by the asset management company for running the scheme and managing your portfolio.

6. Exit load: Some schemes may have an exit load – a fee charged if you withdraw your investments before a certain duration (such as a year).

7. Mode of investment: You may invest in lumpsum or in regular instalments via a systematic investment plan (SIP). You may choose a lumpsum investment if you have a large sum to put in at one go. If you prefer consistent investments in smaller instalments, you may opt for an SIP.

8. Taxation: Consider the tax implications on your investments. Capital gains on debt mutual funds that are redeemed in a financial year are added to your annual income and taxed as per your income tax slab. For equity mutual funds, post Budget 2024, capital gains are taxed at 20% (plus applicable surcharge and cess) if redeemed within a year and 12.5% (plus applicable surcharge and cess) if held for more than one year.

9. Direct vs regular: Consider whether you want to invest through a mutual fund distributor (called a regular plan) or directly through the asset management company or an aggregator.

Other factors to consider

Diversification: Diversification is based on the age-old saying – ‘Never put all your eggs in the same basket.’ In terms of mutual fund portfolio construction, this means that it is always ideal to spread one’s investments across different types of assets and funds. So, you may choose to distribute your investments across different asset classes such as equity, debt, and commodities to spread the overall portfolio risk. Additionally, within an asset class, you may choose more than one type of fund to get exposure to different investment styles, market capitalisations, sectors, or themes.

Review and rebalance regularly: Investing is not a one-time process. It is important that you periodically review your portfolio. You may also need to rebalance the portfolio periodically by adjusting the asset allocation based on changes in market conditions, investment goals, and risk tolerance.

Conclusion

Choosing a suitable mix of mutual funds in India requires careful consideration of various factors such as financial goals, risk tolerance, investment horizon, and diversification. The fund performance and fees can also sway investment decisions. However, by following the steps outlined above and seeking professional financial advice if needed, investors can build a well-diversified mutual fund portfolio tailored to their individual needs and preferences.

FAQs

How to choose the right mutual fund?
Choosing the right mutual fund depends on your unique financial goals, risk appetite, and the overall economic climate. There is no one-size-fits-all approach when it comes to mutual fund investing.

Are equity funds risky?
While equity funds are inherently volatile over the short to mid-term, they have historically generated a higher return potential over the long term.

Which is the safest mutual fund?
No mutual fund is completely safe. However, debt funds typically entail low or moderate risk, while equity-oriented funds are usually high risk. Overnight funds – debt funds that invest in overnight securities – are among the lowest-risk options.

Which is the best mutual fund for beginners?
Most mutual fund categories are suitable for beginners as they are professionally managed, meaning that you do not need financial expertise to invest. So, the suitable mutual fund category will depend more on your investment objectives and risk appetite, rather than experience level. However, beginner investors may consider hybrid funds so that they can diversify across debt and equity through a single investment.

Which mutual funds give the highest return?
Equity mutual funds typically give higher returns than debt funds. However, returns are not guaranteed and fluctuate based on market conditions. Equity investors are advised to have a long investment horizon to tide over short-term volatilities.