We have been looking at Credit Cards for some weeks now. Let’s check another very important tool for your financial independence - Mutual Funds. They give you the growth of the equity market, but do not require you to have the full know-how of how equity markets work or the troubles of reading through the balance sheets of n-number of listed firms. Now there are a couple of ways to go about it. One, you check the most popular and talked about funds on social media and start buying them, or you can actually understand how these work and create a balanced portfolio of funds for yourself that complement each other.
This article would be for the folks interested in the second approach. So if you fall in the first category, who believe in investing the most talked about funds, you can probably ignore the later part of this discussion.
Mutual Funds are not something that we can cover up in a single article or discussion. I will be trying to create a series of such articles where we discuss all the different types of it. So that you, the reader, are able to make better informed choices about your investment decisions. And, we shall be taking it slow, right from step 0, not even step 1, so that everyone can follow the later articles where we discuss more advanced concepts of Mutual Fund investments.
For anyone who hasn’t started on their investment journey, mutual funds are one of the best ways to invest. Why do I say that? Well, as mentioned earlier, they give returns almost in line with the equity markets, but you do not have to spend the time to study and pick each stock to invest in. As normal corporate workers, we also do not have this luxury of time. The next thing, as SIP, or Systematic Investment Plan, one learns about the discipline that is required to invest. Investments aren’t just about putting money in one instrument after the other without a thought and hoping for a 10x return. Read what every great investor has written and you will understand that at its base, more than anything, investment is about discipline. Discipline of investing in the right assets and discipline of staying invested through the peaks and troughs of the market’s waves. The third advantage is, your money is being handled by a professional who has spent their life studying the market and its movements. And 8/10 times, they generally would make better investment decisions than us, if we had invested that money ourselves.
Okay, so now that we have some background on why Mutual Fund Sahi Hai, let’s talk a bit about how they work. Essentially mutual funds are a Contribution Fund. As an individual/retail investor, we do not have the huge sums of money that large institutions or HNI’s have. So what is done is, money, in the form of SIP or lumpsum is collected from hundreds and thousands of individuals, and then invested into the equity/debt market by a fund manager. This is done via a host of different funds. And we will be talking about these different funds today. Again, the number of funds that Indian institutions have created is enormous. But as always, we will look at the base of them first and then slowly get into each of them so that there is not a lot of information bombardment on you.
Effectively, there are only 2 types of Mutual Funds (yes you read it right) - Equity and Debt. All the others that you see when you browse through different mutual fund sites are a permutation and combination of these or within these.
Equity Funds, invest in the equity market. Now they can be further divided into numerous types such as Large cap, Mid cap, Small cap, Flexi cap, and so on. Debt Funds invest in debt instruments such as government and corporate bonds. They can also be subdivided into Ultra Short Term, Short Term, Mid Term, Long Term, Liquid, etc.
Each of the above subdivisions come with their own set of risks and rewards. And us as investors should at least know about it before putting any money in them based on our own risk appetites.
Mutual Fund returns are calculated based on their Net Asset Values or NAV. Which is calculated as -
NAV = (Assets/Liabilities) * Total Number of Shares
For Debt funds, the total number of shares would be the number of bonds held by the fund.
In this formula, Assets is the value of all the assets plus cash that the funds hold at the moment; and Liabilities is the funds payable money, interest and expense ratio.
When you invest in a Mutual Fund, you are buying Units of that Fund at the NAV rate. As the underlying NAV value increases, so does your investment value. Suppose, 3yrs ago, I bought 100 units of a Fund at NAV of 20. My total investment would be about INR 2K. Today, the NAV of that same fund is 35, so my investment value has gone up to INR 3.5K. Similarly, if the NAV today was at 15, my investment would’ve gone down to INR 1.5K and I would be looking at a loss in my investment. When investing in Mutual Funds, knowing about these basics is really important.
Lastly, the most important part, discipline through SIP. Let’s take another example. Say I invested a lump sum of INR 100K in a fund at the NAV of 25, 5yrs ago. Today the value of the funds NAV is 45. My total corpus would be something like -
Total Corpus = (Invested Amount/NAV when invested) * Current NAV
= (100,000/25)*45
= INR 180,000
Now, let’s take the same example and tweak it a bit. This time, I do not invest as lump sum, but as a yearly SIP of INR 20K for 5yrs. Incrementing the value by a mere 5% each year. It is also important to remember that the equity market is volatile and has its ups and downs. And so, the yearly contributions could look like the following -
This would result in accumulation of about 4093 units which when multiplied by the latest NAV would give a total corpus of over INR 184K. A cool 2% extra on your previous returns, without the added stress of arranging a lump sum amount for investment. This is also called Rupee Cost Averaging. As a salaried class, this becomes the best way to invest in the long term. Lump sum investments also require timing the market a bit, because you do not want to jump in holding all your eggs into the market when it's at a very high level! That would mean buying fewer units at high NAVs which might not rise further up in the short or medium term.
I hope this information helped you in understanding how mutual funds work at a high level and how you can best invest in them. We shall talk more about the Equity Mutual Fund class in the upcoming chapter which will give insights on the types of Equity Mutual funds, their risk profiles and which type would suit what kind of investor. If you like the topics covered here, do make sure to share it with your family and friends who want to learn more about investments. And also drop a comment if you want to learn more about a certain asset class.
This article really helps! Thanks
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