Why most new investors start with mutual funds

Find out why mutual funds make the most sense for new investors

If you are a regular viewer of Indian television, then at some point or another you’ve definitely come across an ad whose tagline is, “Mutual funds sahi hai.”

Pretty sure that the makers of the ad came up with the concept to get, you, the viewer intrigued about mutual funds, so intrigued that you end up googling them.

But, did you?

Probably not.

Now that you’re older and wiser, and want to learn more about mutual funds, hopefully, your search for the reason behind their “sahi-ness” ends here and find the motivation to set out on your journey of personal finance.

So, what is a mutual fund?

At its core, a mutual fund is a company, one whose sole purpose is to invest people’s money and try to get them the best profits possible.

Each fund has an objective according to which it builds up its portfolio with equities, bonds, and other securities. All funds have a fund manager and a bunch of analysts who evaluate the best securities to invest the money, pooled in from all the investors.

This pool of money is called Asset Under Management (or AUM).

Generally, the fund managers are owners of the fund and may even have a substantial amount of their own money invested in it. And to top it off, their incentives are proportional to the fund’s performance. So you can, most of the times, trust them to treat your money like their own and invest it wisely.

Mutual funds are a good option if you don’t know what you’re doing and/ or you do not wish to spend a lot of time worrying about investments. They’re the easiest way for the general public to get access to professionally managed funds.

How does a mutual fund work?

You must be having a general understanding of how stock markets work. A stock market has stocks of various companies, people trade the shares of these stocks, and whose price fluctuates based on their demand. This demand can pull the prices higher or push them lower in very small periods, which makes them very volatile and risky. If you’re not following up on them regularly, you can miss out on opportunities to make a profit, or worse, even risk losing capital.

So just like a stock has shares, a fund has units, you purchase these units for a price called Net Asset Value (or NAV). Unlike the share price of a stock, this price does not change during the day. Instead, it is calculated at the end of every trading day, based on the value of assets in the fund’s portfolio and other parameters. Parameters which make for some really boring math and can lead to loss of interest in the topic.

Carefully skirting the boring stuff, let’s move towards some more interesting and probably more useful stuff.

Types of Mutual funds and Risk

Remember reading something about each fund having an objective, earlier?

Yes, that.

So let’s pick things up from there, each fund has an objective, one which dictates the kind of securities and/ or industries to which it should restrict its investments to. And based on those objectives, mutual funds can be segregated into various categories.

Brace yourselves for a terminology typhoon.

Large cap/ Blue chip funds-

These funds invest in only stocks of large and established corporations. Such stocks are less volatile during rough markets and give almost consistent returns, almost. These organisations tend to grow more slowly but consistently, and as a consequence, are less risky. So chances of making a quick profit are low, but make for great long term investments.

Mid cap funds-

These invest in stocks of slightly smaller companies and are more volatile than large cap funds, and can therefore give you relatively greater profits and greater losses.

Small cap funds-

These are smaller companies that you might not have heard of, but, because they’re small, they have a lot of headroom left to grow and can give even greater returns compared to the large and mid cap stocks. But they are generally more vulnerable in rough markets and can fall just as quickly as they can rise. Greater the risk, greater the reward.

Multi cap funds-

These funds have a portfolio that’s made up of combination of stocks of all sizes and are inherently less riskier.

Debt funds-

Debt funds invest in bonds, rather than stocks.

But wait, what’s a bond?

Bonds are securities which are used by companies and governments to raise funds. At its core, a bond is a loan through which the public lends these bodies money and the loaned amount earns a fixed rate of interest in return.

These are highly risk averse investments and assure fixed returns, but as is the nature of investments — or anything else under the sun — low risk equals low reward.

Arbitrage/ Hybrid funds-

You guessed it, these have a mix of stocks and bonds in their portfolio. So the volatility of the markets are balanced by stable and assured returns of bonds.

Index funds-

If you’ve ever been a part of a conversation discussing the markets, then you’ve definitely heard the words “Sensex” and “Nifty” being thrown around. You obviously heard those words and wondered what they meant, but then weren’t curious enough to go look them up. Maybe because you thought they’d be too technical, or that googling them would unleash a huge storm of jargon. But in reality, they’re simpler than you might have perceived them to be.

So what’s an index?

A stock market index is a statistical tool that is used to measure a stock market. Each index is composed of a list of large, well established, and actively traded stocks in that exchange. And by using the performance metrics of these stocks, such as market capitalisation, etc. the value of the index is calculated. What this gives us, is a standard metric that lets us compare the performance of the market at different periods.

Bombay Stock Exchange (or BSE) has Sensex, it is derived from the list of 30 well established companies listed on the Bombay Stock Exchange (or BSE). NSE has Nifty 50, NYSE has Dow Jones, you get the point. There are even indices generated for stocks belonging to a particular industry listed on that exchange. So, electrical manufacturing industry would have an index, financial companies would have one, as would the automotive industry.

Index funds will invest in companies listed in these indices and try to mimic their patterns. These are good for long term gains.

International funds-

When a big storm hits any country, then, almost all of its securities and markets fall. And this deals a huge blow to the investors, as well as the country. So, to save your portfolio from crumbling completely, you diversify.

You ensure that you spread your investments across different industries and securities, hoping that, in the event of an economic meltdown of a particular industry, others stay safe.

But, if you want a more robust way of isolating your investments, you head towards markets of other countries. While it is difficult for a person to invest in markets of other countries, they can easily do so with the help of international mutual funds.

These funds invest in securities of other countries, providing the investors with an easy path to diversification.

So are mutual funds “sahi”?

Absolutely, but only if you spend some time every month tracking their performance and practising the versatile art of patience. Because, just like us, mutual funds also have their good and bad days, so you just gotta be patient and sit through them.

Here’s a list of all the good things about mutual funds which make them so appealing, summarised.

• They’re easiest way to professionally managed funds.
• Somewhat insulated against the volatility of markets.
• Easy diversification.
• If you’re someone who does not want to spend their days worrying about investments, then mutual funds are for you.
• Theres a mutual fund for everyone and every risk profile.

What next?

Itching to take your first steps in the world of investing?

Follow the link below to find the step by step guide to investing in mutual funds and learn about various options to invest in them.

3. How To: Mutual Fund Investing

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