How to choose mutual funds?

Mutual funds offer investment solution for a variety of investment needs for investors in all age groups. You can invest in them with an aim to create wealth, achieve different life-stage goals e.g. retirement planning, children’s higher education, vacation planning, property purchase or create an income stream during retirement. But, the most important Question that arises before you start investing is how to choose mutual funds which may meet your investment objectives?

Before you endeavour how to choose mutual funds, you must know the following 3 things -

  1. Financial goals

    Defining different financial goals is most important aspect to prepare an investment plan. You should lay-out all your goals in different stages of life factoring in inflation so that you have an actionable plan i.e. how much and where to investment and for how long! Once these are ready, you should think of how to select mutual funds which helps in meeting these objectives.

  2. Risk Appetite

    Risk refers to an adverse financial outcome against your expectations. Some people have higher capacity to take risks than others. Your risk appetite depends on your age, stage of life, personal and financial situation. If you can assess your risk well, you will know how to pick a mutual fund basis your risk appetite.

  3. Asset allocation

    Different asset classes have different risk profiles e.g. debt funds usually have lower risk than equity funds. You should understand that risk and returns are directly related. Asset allocation aims to balance risk and return in achieving your financial goals. If your risk appetite is higher, you can have higher allocation to equities and vice versa. You should invest in the right asset class depending on your financial goal and risk appetite and for that you need to know how to choose the right mutual fund.

How to choose mutual funds in India?

Below are some factors, which if considered, you will know how to choose a good mutual fund considering your financial goals, risk appetite and asset allocation -

  • Investment horizon: It will depend on how long you have to reach your financial goal. If you know how to choose the right mutual fund, you will know that equity funds are best suited for meeting your goals with long investment horizon and debt funds are best suited for short to medium term goals. For very short investment tenures (less than 1 year), funds like overnight funds, liquid funds, ultra-short duration funds etc are suitable.
  • Investment objective: Before you try to know how to select the right mutual fund you must know your investment objective! Do you want growth or regular income? Equity funds are best suited for capital appreciation in the long term while debt funds are suitable if you want regular income.
  • Risk profile: If you know your risk profile, you will easily know how to choose the right mutual fund! You should know the risk profile of a scheme to ensure that you are taking the right amount of risk. Equity funds are suitable for investors with moderately high to high risk appetites while bond funds or debt funds are suitable for those with low to moderate risk appetites.
  • Taxation: In your pursuit of how to choose a good mutual fund, taxation is one of the most important criteria as you must know the tax consequences of your investments before you start. For example - Short term capital gains (held for less than 12 months) in equity funds are taxed at 15% and long term capital gains (held for more than 12 months) are tax exempt up to Rs 1 lakh and taxed at 10% thereafter (in excess of Rs 1 lakh of capital gains). Short term capital gains (held for less than 36 months) in non equity funds are taxed at as per your income tax rate and long term capital gains (held for more than 36 months) are taxed at 20% after indexation benefit is allowed.
  • Lump sum or SIP: If you have known how to select the right mutual fund then you should figure out if you can invest in lump sum or through SIP. By investing through SIPs, you can benefit from rupee cost averaging and power of compounding. In case you have ready funds, you can invest in lump sum according to your optimal asset allocation.
  • Fund manager and fund house track record: You should check the long term track record of the scheme, its fund manager and also the fund house before investing.
  • Expense Ratio: Fund expenses will come out of your returns. Expense ratio is important for certain types of investments like index funds or Exchange Traded Funds (ETFs). In actively managed funds, the fund manager’s ability to generate high alphas may compensate for higher expense ratios. Index funds or ETFs on the other hand, do not aim to create alphas and merely track the index. So expense ratio is important in index funds and ETFs.

Mutual funds offer products that can provide solutions for a large variety of financial goals, investment tenures, risk appetite and liquidity needs. If you evaluate the factors discussed herein, you will know how to select mutual funds in India. Evaluate these factors and make informed investment decisions before selecting the best mutual funds. You should always take the help of a financial advisor if you have difficulties in understanding the investment characteristics of mutual funds.

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