Making The Right Investment

A steady increase in financial literacy and declining returns from fixed-income investments attracted many retail investors towards investing in mutual funds. If you are also one of those or are contemplating exposure to MFs, here are some tips to generate optimal returns from mutual fund investments.

Consider your risk appetite during fund selection

One’s risk appetite would primarily depend on his income stability, liquidity, and investment horizon of financial goals. For instance, retail investors should choose equities for their long-term financial goals as equities as an asset class usually outperforms fixed income instruments and inflation by a wide margin over the long term. A longer time horizon also provides more time for equity mutual fund investments to recover from the losses caused by market volatility. Likewise, investors witnessing acute income uncertainties might have to put aside a higher amount in debt mutual funds to preserve their capital and liquidity for dealing with periods of strained cash flows and incomes. As different mutual fund categories suit different levels of risk appetite, make sure to consider your risk appetite while selecting your funds.

Opt for the direct plan over the regular plan

Direct plans come with a lower expense ratio than the regular plans as fund houses do not incur any distribution expense for their direct plans. Thus, savings generated in distribution expenses stay invested in the direct plans of funds, which begin yielding returns on their own over time owing to the power of compounding. All such factors make direct plans to yield higher returns than regular plans.

Suppose an investor begins investing Rs 10,000 per month in a regular plan of an equity fund having an expense ratio of 2 per cent for 20 years. His investment corpus would grow to Rs 73.41 lakh assuming the annualised return to be 12 per cent. However, if the retail investor instead invests in direct plans of the same fund with an expense ratio of 1 per cent for the same investment horizon, his corpus would be Rs 84.25 lakh at the end of the 20-year time horizon. The difference in the corpus would be about Rs 10.84 lakh with direct funds outperforming their regular counterpart by 13 per cent. Thus, always prefer direct plans over regular plans to build a higher corpus over the long run.

SIP allows one to invest a predetermined sum at regular intervals (monthly, quarterly) in a mutual fund. As the amount for SIP gets debited automatically from one’s savings account on the ascertained date, it instills financial discipline and the habit of regular investment among investors.

Moreover, as the minimum investment amount in most equity mutual funds usually starts with just Rs 1,000 and Rs 500 in the case of ELSS funds, investors with limited monthly investible surpluses can also benefit from equity investments, and the power of compounding.

Automated and periodic investments also ensure rupee cost averaging by purchasing more units at reduced NAVs in times of falling markets. This assists in averaging investment costs and also removes the requirement to time investments and monitor markets.

Diversify your investments

Returns yielded by different mutual funds can vary drastically basis fund managers’ investment decisions, the asset classes they are invested in, the kind of fund categories those funds belong to, overall economic and market conditions. For instance, asset classes like equity and gold share a negative correlation. Gold funds generally perform well during geopolitical and economic uncertainties while equities generally falter during such uncertainties. Likewise, short term debt funds do better than long term debt mutual funds during rising interest regimes and vice versa. Hence, having a proper portfolio diversification through optimum exposure to various funds across fund houses and within/across asset classes would help in generating optimum risk-adjusted returns.

However, note that you should avoid getting into the trap of over-diversification or purchasing multiple funds with similar investment strategies and styles. Having too many funds in your portfolio would make it tough to keep track of funds’ performance and can also adversely affect your overall portfolio returns.

Review your fund performance at regular intervals

Reviewing your mutual funds at regular intervals is as crucial as regular investing and optimum fund selection. Periodical review of your mutual fund portfolio will allow you to compare your funds’ performance in different market conditions vis a vis their peer funds and benchmark indices.

Remember that even star funds generating high returns in the past can become consistent underperformers in the future. Thus, make sure to compare the returns of your funds’ over the past one-year period with their benchmark indices and peer funds once every year. In case existing funds underperform their benchmark and peer funds constantly for the past three years, redeem them for better performing funds.

The author is Director, Paisabazaar.com