Equity vs. debt funds: Which is better for short-term investment?

The choice between equity and debt mutual funds is not always only about personal preference. A number of factors need to be considered, such as investment horizon, goals and risk appetite. This is especially true when you are looking to invest your money for the short term.

Let’s take a closer look at equity vs. debt funds, so that you can decide which is better for your short-term investment goals. We'll explore what each type of fund is, what factors to consider before investing, and how they compare to one another.

• Table of contents

1. What are equity mutual funds?
2. Equity mutual funds as a short-term investment option
3. Factors to keep in mind before investing in equity mutual funds
4. What are debt mutual funds?
5. Factors to keep in mind before investing in debt mutual funds
6. Differences between equity mutual funds and debt mutual funds
7. Equity and Debt Funds - Which is better?

What are equity mutual funds?

Equity mutual funds invest your money in the shares of various companies. Return potential is linked to the performance of these companies in the stock market. Such funds have the potential to offer high returns, but they also come with high risk because stock prices can fluctuate significantly in the short term.

There are different types of equity mutual funds based on market capitalisation, such as large-cap, mid-cap, and small-cap funds. Large-cap funds invest in well-established companies, which are generally more stable but offer moderate return potential. Mid-cap and small-cap funds invest in smaller companies with higher growth potential but also higher risk. There are also sector-specific equity funds that focus on particular industries, like technology or healthcare. These offer targeted exposure, which can be highly beneficial when those sectors are doing well, but this also means greater vulnerability to sector-specific risks and less diversification.

Equity mutual funds as a short-term investment option

Equity mutual funds are usually not recommended for short-term investments, for the following reasons:

• Market volatility: Equity markets are known for their short-term volatility. Stock prices can fluctuate significantly due to various factors such as economic data, corporate earnings, geopolitical events, and market sentiment. In the short term, these fluctuations can lead to unpredictable returns, making it risky for investors who need access to their funds in a short period.
• Risk of capital loss: In the short term, there is a higher risk of capital loss with equity mutual funds. If the market experiences a downturn or a correction, the value of equity investments can decline sharply. Investors who need to liquidate their investments within a short period might have to sell their holdings at a loss.
• Reduced compounding opportunities: Compounding is a significant driver of wealth. Compounding happens when the returns on an investment are reinvested, going on to earn further returns. Over time, if the investment base grows, the effect of compounding typically accelerates and can lead to significant growth in the long-term. However, time is a key driving force for compounding.
• Exit loads: Many equity mutual funds impose exit loads if the investment is redeemed within a specific period, usually six months to one year. These exit loads can reduce the overall returns for short-term investors. The purpose of exit loads is to discourage short-term trading and to encourage investors to stay invested for the long term.
• Historical trends: Historically, equity markets have shown better performance over extended periods compared to short durations. While past performance is not indicative of future results, the general trend has been that equity investments reward patience and a long-term outlook.

Factors to keep in mind before investing in equity mutual funds

• Risk tolerance: This is the most important factor to consider before you choose to invest in equity mutual funds. Understand that equity funds can be very volatile. If you can handle ups and downs in your investment value, equity funds might be suitable for you.
• Market knowledge: Knowing about the stock market can help you make better decisions. Even though equity mutual funds are managed by professionals, having some market understanding is beneficial. This knowledge can help you understand fund performance and market trends.
• Financial goals: Consider whether you’re investing for retirement, a home purchase, or other long-term goals, and then ensure that your financial goals align with the potential returns and risks of equity funds.
• Fund manager's experience:The expertise and track record of the fund manager plays an important role in the performance of a mutual fund. A skilled fund manager can effectively navigate market changes to mitigate risk and optimise return potential.

What are debt mutual funds?

Debt mutual funds invest in fixed-income instruments like bonds, government securities, and treasury bills. A debt security represents a loan given by an issuer (such as the government or private company) to an investor. In return, the bond issuer agrees to pay regular interest and repay the principal amount at maturity. Though not risk-free, debt mutual funds are usually less volatile than equities and have relatively stable return potential.

There are various types of debt funds, including liquid funds, short-term funds, and long-term funds, each with different maturities and risk profiles. Liquid funds invest in very short-term securities, offering high liquidity and low risk, making them ideal for emergency funds. Short-term debt funds invest in securities with maturities ranging from one to three years, providing a balance of liquidity and higher return potential than liquid funds. Long-term debt funds invest in bonds with longer maturities, which can offer higher return potential but come with increased sensitivity to interest rate changes.

Understanding the difference across these categories can help you choose the right debt fund based on your investment needs and risk tolerance.

Debt mutual funds as a short-term investment option

Debt mutual funds are generally considered more suitable for short-term investments for the following reasons:

• Lower risk:: Fixed-income securities are generally less volatile compared to equities, making them more suitable for short-term investment horizons where mitigation of impact on capital is crucial.
• Relative stability: If the debt issuer holds up its obligations, debt funds can provide relatively predictable return potential, especially if held till maturity. Investing in high-quality papers can mitigate this risk of default. So, debt mutual funds with short-duration securities can be suitable for near-term goals.
• Better return potential than traditional savings avenues: Debt mutual funds offer better return potential than traditional savings accounts, recurring deposits or short-term fixed deposits, especially in a low-interest-rate environment. Moreover, they are liquid, unlike fixed and recurring deposits, meaning you can withdraw all or part of your funds when needed. This provides investors the opportunity to access higher return potential on their funds while maintaining a relatively low-risk profile and high liquidity.

Factors to keep in mind before investing in debt mutual funds

Before investing in debt funds, investors should assess certain factors and key considerations. These include risk appetite, interest rate environment, tax implications and more, detailed below:

• Risk appetite: Debt funds are generally more stable than equity funds, making them suitable for conservative investors. However, it’s important to recognise that they are not completely risk-free.
• Interest rate risk: Debt funds can be affected by changes in interest rates, which can influence the return potential. An increase in interest rates can decrease the value of existing bonds, affecting the fund’s net asset value.
• Credit quality: Check the credit quality of the securities in which the fund invests. Higher quality bonds mean lower risk. Look for funds that invest in high-rated securities to ensure better stability.
• Expense ratio:Consider the expense ratio of the debt fund, which includes the management fees and other costs. A lower expense ratio means a higher portion of your returns remains with you. Comparing the expense ratios across different funds can help in choosing a cost-effective option.
• Tax implications: Capital gains on debt funds are added to the investor’s income and taxed as per their income tax slab, regardless of whether they’re held for the short or long term.
• Fund manager's experience: The expertise and track record of the fund manager can play a significant role in the performance of a mutual fund. A skilled fund manager can effectively navigate market changes to mitigate risk and optimise return potential.

Differences between equity mutual funds and debt mutual funds

Criteria	Equity mutual funds	Debt mutual funds
Risk	High risk	Low to moderate risk
Returns	Potential for high returns	Moderate return potential
Investment horizon	Better for long-term owing to mitigate volatility and other risks	Ideal for short-term, medium term and long-term
Volatility	High volatility due to stock market changes	Low volatility
Investment type	Stocks and shares	Bonds and fixed-income securities
Suitability	Aggressive investors	Conservative investors

Equity and debt funds: Which is better?

The choice between equity and debt funds depends on various factors, including risk tolerance, financial goals, diversification needs, investment horizon, and tax considerations.

Risk tolerance and financial goals:

Equity funds: Suitable for investors with a higher risk appetite and long-term goals. They offer the potential for significant capital appreciation over time but also come with higher volatility, especially in the short term.

Debt funds: Ideal for investors seeking lower risk and relatively stable return potential. They are suitable for short-to-medium-term goals like emergency funds or purchases.

Diversification: A balanced portfolio that includes both equity and debt funds can help manage risk and optimise return potential.

Investment Horizon:

Short-term: Debt funds are generally more suitable for short-term goals.

Long-term:Equity funds can be advantageous for long-term goals due to their potential for higher returns.

Tax implications:

Equity funds:20% on short-term capital gains (on units held for less than a year) and 12.5% on long-term gains (units held for more than a year). Long-term gains of up to Rs. 1.25 lakh are tax-exempt.

Debt funds:All gains are taxed as per the investor’s prevailing income tax slab, regardless of the holding period.

Conclusion

Deciding between equity and debt funds depends on your investment goals, risk tolerance, and time horizon. For short-term investments, debt funds are generally a more stable option. Always consider your financial situation and consult with a financial advisor to make the best decision for your needs.

FAQs

Which is better, debt fund or equity fund?

Debt funds are better for short-term investments because of their lower risk and potential to offer relatively stable returns, while equity funds are more suited for long-term investments as they entail higher risk but offer higher return potential in the long term.

Can I invest in equity and debt mutual funds at the same time?

Yes, you can invest in both equity and debt mutual funds simultaneously to diversify your portfolio and balance risk and return potential.

Which is riskier, equity or debt?

Equity funds are riskier due to their high volatility and dependence on stock market performance.

Which SIP is better, debt or equity?

For short-term goals, a debt SIP is better due to lower risk. For long-term wealth creation, an equity SIP offers better potential.

When to invest in debt or equity?

The decision to invest in debt or equity depends on factors. Equity is generally preferred by investors who are looking for long-term growth potential and have higher risk tolerance. Debt is generally preferred by investors with short-term Goals and lower risk appetite.

Do debt funds come with zero risk?

While debt funds are often perceived as a relatively stable investment avenue compared to equity funds, it's important to recognise that they are not risk free. Factors such as fluctuations in interest rates, the creditworthiness of issuers, and liquidity can impact the performance of debt funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.