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Chapter 3.4: How to choose a mutual fund?

Choose according to your risk appetite. Evaluate cost, past performance, extent of diversification, and the fund manager’s strategy before you decide.

Summary:

  • A mutual fund can never be completely free of risk. But you can choose wisely to minimise the extent of risk exposure.
  • Look at the past performance of a fund to assess how stable it is and what returns you may expect.
  • A diverse portfolio, a good fund manager, and the patience to weather market ups and downs should see you get good returns.

How to choose a mutual fund

As an investment, a mutual fund has several benefits. It offers a higher rate of returns than most conventional investment instruments. You are guided by experts in the field who help develop your investment strategy. You can start with a very modest sum. You don’t have to deal with the unnecessary hassle of chasing paperwork. And if that’s not enough, you can disinvest at will, opting to liquidate your fund when you choose.

If you have chosen to invest in mutual funds, it is a great decision. But how do you know which fund is the right one for you?

(Read more: What is a mutual fund?)

Factors that help you choose

Performance record of a fund: A fund’s track record is the first thing you should look at.

  • How has it performed over the years?

  • Has it been consistent in giving returns?

  • What has the fund manager’s strategy been like?

  • Did it manage to override normal turbulence in the market?

Past performance gives you an idea of how stable the fund will be in the future. You can assess roughly what kind of returns you may expect if there are no drastic changes in the economy.

Check out both short-term and long-term returns. Did people who invest for one year get good returns? What about two-year investments? Ask for the figures. How did the fund perform when the market was sluggish? A strong fund would weather a bearish market without much change or a drastic fall. Look at the last downturn and see how the scheme fared.

(Read more: Mutual fund terms and concepts?)

Does the fund match your risk appetite? Mutual funds always offer some risks associated with the market. This may be high or low, depending on the kind of assets the fund invests in. You need to be careful here. Assess your risk appetite and think of your investment horizon. Say, you want to stay invested for three years. You may have a certain goal in mind. You may want to build a certain corpus. Or, you know you can’t afford to risk beyond a certain amount of money. This stock-taking will help you choose the right fund.

Ask the right questions:

  • Do you want a high-risk fund that offers the possibility of high returns?

  • Do you want as little risk as possible?

  • Would you be comfortable investing only in debt funds for modest returns?

  • Are you open to the idea of a cautious risk?

  • Would you rather have a mix of equity and debt funds to balance the risk?

How diverse is the portfolio? A healthy mix is good for you. It balances risk. When your portfolio is diverse, it simply means that you are investing in different assets and different sectors. So, your portfolio may have a mix of debt and equity instruments. Or, you may have a mix of sectors or industries that you have invested in. This protects your money from being lost due to a crash in any one particular industry. It’s a matter of not keeping all your eggs in one basket.

(Read more: What is an equity fund?)

What are the costs? A fund may offer high returns. But does it have a high cost? What is the net profit you’d be making? Think about whether you will be better off investing in a low-return fund that has low cost. This could push up your profit margin. Calculate carefully. Say, you want to stay invested for five years. Even a 2% difference would add up to a lot.

The fund manager: One of the biggest advantages of mutual funds is that you get professional advice and guidance to help you invest wisely. But the experts themselves make a big difference.

Say, a fund has been very successful in the past. But the earlier fund manager suddenly is not managing the fund any longer. Would you feel comfortable investing with a new manager handling the fund? It may be a better idea to wait and watch how it does under a new manager. Ask around about the fund manager and their investment strategy. Invest only if your vision matches theirs.

Even after you tick off everything, there is no fail-safe strategy here. Every fund carries a certain risk. You can’t eliminate it, but you can certainly take a calculated risk. You can calibrate your exposure to risk.

Read all the fine print. The prospectus that comes with a fund tells you what to expect. Funds with higher returns may carry higher risks. So, you will have to figure out what you want—the chance to make more money or to protect your investment from being lost.

Just remember one thing: Patience pays. If you wait and stay invested, your chances of getting reasonable returns will be higher. Do not give in to knee-jerk reactions to market changes. Don’t buy or sell when the market turns. But don’t hold on to a poor performer either. A dose of judiciousness, a modicum of risk-taking, and a good fund manager should help you make the most of your mutual fund investments.

(Read more: How mutual funds work?)

WHAT NEXT?

We are almost at the end. Before you start investing in mutual funds, there are a few more important points to keep in mind like taxation. This can affect your total financial returns. To know about these factors, Click here

Why Capital gains report?
  • Snapshot of profit/loss
  • Reflects performance of your portfolio
  • Helps compute taxes
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