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Know the basics of mutual funds before venturing

Author: Team Finapolis/Sunday, January 21, 2018/Categories: Mutual Funds

Know the basics of mutual funds before venturing

With the penchant for savings going beyond the traditional bank deposits and post office savings scheme, there has been an increasing brouhaha in the mutual funds industry. Though this upheaval is sudden, the industry itself is half a century old and has maintained its momentum since the beginning. Prior to investing in the industry, one should know the basics of mutual funds. To start with one should know what mutual funds are.

What is a mutual fund?

A mutual fund is an investment option in which a number of investors pool their money in a fund that is professional managed. The fund comprises securities of different sectors to diversify the risk. The investor gets units of the mutual fund according to the amount of money invested.

Benefits of investing in mutual funds

Most beginners ask the question, “Why should we invest in mutual funds?” Like stock trading, mutual fund investment too is fraught with risk as it is aligned to the equity markets. Yet, it is one of the preferred modes of investment in every household. This is because mutual funds do not put all the eggs in the same basket or invest in a single company. The diversification of portfolio into various sectors mitigates the risks related to the markets.

One of the popular myths about mutual fund investments is that it is meant for experts only. On the contrary, mutual funds are for the common investors who need not have a thorough knowledge of the markets. Mutual funds are professionally managed by fund managers who choose each component after extensively researching their performance. Over and above this, all asset management companies are regulated by the Securities and Exchange Board of India which quickly deals with any discrepancy.

To summarise, the chief advantages of investing in mutual funds are:

  • Professionally managed
  • Diversified portfolio
  • Low cost on investment
  • Highly liquid in nature
  • Easy to invest
  • Well regulated

Disadvantages of investing in mutual funds

There are limitations in all investments and it is equally important to be aware of the disadvantages before investing. In mutual fund investments, one of the primary drawback is the high operating and management fees charged by the fund houses. This is known as the expense ratio. The expense ratio is defined as an annual fee that unit holders have to pay for management, administration, operation and asset based costs of the fund. These charges, however, do not include brokerage costs or transactions fees. Apart from these charges, there are other disadvantages of mutual fund investment such as:

  • Lock in period
  • Trading limitation
  • Loss of control over choice of securities
  • Lack of insurance against losses

Strategy of investing in mutual funds

Post weighing the pros and con of investing in mutual funds, the next step is to strategise the approach in which one can invest. Systematic investment plan (SIP) is one of the most popular ways of investing in mutual funds. SIP is a method in which one can buy units of a mutual fund scheme on a given date each month. The system allows one to invest a fixed sum of money at regular intervals for a specific time. Investment through the SIP can be as low as Rs 500.

Some of the benefits of investing through systematic investment plan (SIP) are:

Building a corpus: SIP helps build a corpus over a period of time and it is far easier to maintain in the long run.

Rupee-cost averaging: Since one is investing the same amount every month, it averages out the cost variations in the market cycle during the bear or bull run.   

Helps achieve financial goals: If planned well and on time, SIP is a good way to meet financial goals by taking advantage of the power of computing. 

Disciplined approach: The approach instils in an investor a discipline in investing.

Flexibility: There is flexibility in the choice of mutual fund.

Apart from the SIP, the investor can also invest a lump-sum amount in a mutual fund. Investing a lump-sum is generally preferable for those funds which have a lock-in period. One of the biggest advantages of a lump sum investment is that it is a one-time affair.

Apart from these, one should be aware of the Systematic Transfer Plan and the Systematic Withdrawal Plan for mutual funds before investing. In a Systematic Transfer Plan (STP) an investor gives permission to the mutual fund to periodically transfer an amount or unit to another scheme. However, on schemes from the same fund house has to be chosen.

A Systematic Withdrawal Plan on the other hand allows the investor to withdraw a certain amount or redeem units at regular intervals. This allows the investor to have a regular income from the investment.

Investments should be made only when there is clarity on the process and product. Hence, it is important to know the basics of mutual funds before investing.

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