6-Step Guide to Choosing the Right Mutual Funds for Beginners

"Mutual funds are subject to market risks" is a phrase perhaps engrained in many of our minds. It is often seen as a complicated concept or an investment choice with risks and no guarantee. Honestly, it can be challenging, especially for beginners, to make a comprehensive decision on choosing suitable funds, but it is undeniably one of the most popular ways to grow wealth. This beginner's guide will explain mutual funds and provide a six-step process for selecting the best mutual funds in India to achieve your financial goals.

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1: Understand Mutual Funds - What Is It All About?

First and foremost, it's imperative to understand the basic design of mutual funds and their working methodology. A mutual fund is an investment option that pools small amounts of money from different investors into a larger sum, which can then be put into different portfolios of securities such as stocks, bonds, gold, and government securities. 

Dedicated and professional experts, technically called fund managers, are tasked with managing these and making investment decisions on behalf of the investors. Hence, because of expert handling and minimal to zero intervention by each investor individually, it is considered very suitable for the majority of investors, both experienced and beginners, who don't want to be directly involved in the buying and selling of securities. This professional management, along with diversification and easy accessibility, are great advantages.

2: Identify Your Goals - What Are You Looking For?

The next puzzle in mutual funds is the various categories and sub-categories that invest in different asset classes. For instance, common mutual fund categories include pure equity funds, debt funds, hybrid schemes, gold funds, schemes that invest in international assets, etc. With so much diversity, one cannot invest in any category randomly and expect attractive returns.

The solution here is to ask. Ask yourself:

Why do you want to invest? What do you intend to get out of it? Do you have medium-term objectives, such as buying a house or funding education, or are your goals long-term, say for retirement? Asking these questions to yourself and arriving at clear answers is a step you cannot miss!

When you can identify your investment objectives, it will be easier to narrow down the types of mutual funds that will work best for you. For instance, if your investment goal is to save up for your post-retirement age, consider an equity-oriented mutual fund with the potential for higher returns over an extended period. On the other hand, if you wish to accumulate money to buy or build a house, you should consider debt funds or liquid funds that prioritise capital preservation.  

3: Assess Investment Strategy - What Should You Focus On?

Each type of mutual fund focuses on different investment strategies. They can be growth-focused, value-focused, or income-focused. Value-focused funds look for undervalued stocks with potential for appreciation, while growth-focused funds prioritise investments in businesses with solid growth prospects. In contrast, income-focused funds place a large portion of their assets in fixed-income securities to provide investors with steady returns.

It is important to assess the investment strategy and decide what works best for you based on your risk tolerance and investment philosophy. If you ensure that the fund's strategy aligns with your investment goals identified in the previous step, then you're on the right track!

4: Evaluate Your Risk Appetite - How Much Are You Willing to Risk?

As different mutual funds carry differing risks, it is critical to evaluate your risk tolerance before making investment decisions. Your risk appetite will determine which mutual fund is best for your investing portfolio.

For example, if you are a conservative investor with a low tolerance for risk, debt funds or large-cap equity funds with generally constant returns may be preferred. On the other hand, if you are a risk-taking investor who is more aggressive, you may choose between mid-cap or small-cap equity funds or even sector-specific schemes, which involve volatility but also have the potential to offer more significant returns.

An important tip is to find a balance between risk and returns. Diversifying investments across various asset classes and investment strategies can reduce risk and maximise rewards.

5: Consider Time Horizon - How Long Can You Keep Investing?

"Time horizon" means the extent of time during which you will continue your investment, either by adding more money or allowing existing investments to grow without having to break them. This is another critical factor to understand before deciding to invest in mutual funds.

If you have a short time horizon, you have a few months to about two years to stay invested in any particular fun. In this case, choosing liquid or short-duration debt funds that provide liquidity and stability could work well for you. 

In contrast, if you can stay invested in a particular fund for a longer time, say 10 years, as you are focusing on wealth accumulation or retirement savings, then you can consider going for equity-oriented funds. These funds are usually subject to fluctuations but have the potential to generate higher returns in the long run and build your wealth massively.

Selecting the right mutual fund category based on your time horizon and financial goal ensures that your investments align with your financial goals and liquidity requirements.

6: Analyse Other Factors: What Else Is There?

You have identified your goals, assessed your risk tolerance and determined your time horizon. Now what?

Well, the final step in choosing the right mutual fund for you to invest in involves evaluating other key factors, including:

Past Performance

Analysing how well the funds have performed in the past is crucial. Although past performance does not always guarantee future outcomes, a considerable degree of reliability can be placed on funds that have consistently generated returns that are better or at par with the market over several market cycles.

Consistency in Returns

When assessing mutual funds, consider the consistency of returns and overall performance. A fund's capacity to perform well in various market conditions is indicated by the consistency with which it produces stable returns over time. Instead of funds with intermittent high returns, look for funds with a history of steady returns.

Comparison with Other Funds

A beneficial practice is comparing your preferred mutual fund's performance against similar funds in the same category. Consider the fund's risk-adjusted returns and how they compare to those of its rivals. For this comparison to be most useful, though, you should choose funds with similar investment goals and strategies.

Track Record of Fund Manager

The effectiveness of a mutual fund investment is greatly influenced by how it is managed. So, look for investments that are managed by seasoned, reliable managers. Consider the fund manager's track record and experience while evaluating potential investments. A knowledgeable and experienced fund manager can handle market volatility and make judgments that align with the overall investment strategy and benefit of large.

Expense Ratio

Every fund house managing mutual funds levies an annual fee, known as the expense ratio. It comprises management fees, administrative charges, and other operational costs. A higher expense ratio means these expenses will consume a small portion of your investments. However, a lower expense ratio does not necessarily mean that you can get more returns. Hence, it is best to thoroughly study and search for mutual funds that offer value for your money and have a fair expense ratio.

Entry and Exit Loads

Most mutual funds have an entry and exit fee, which investors bear when they enter or exit the fund within a specific time frame. Consider whether these loads fit your time horizon and liquidity needs. Investors are looking for investments with low or no entry and exit loads to have optimum returns.

Assets Under Management (AUM)

A mutual fund's assets under management (AUM) indicate both the size of the fund and the investors' confidence. Although a fund may be more popular if its AUM is bigger, other criteria must also be taken into account. A fund with a high AUM may struggle to deploy funds efficiently or generate alpha. To make a well-informed selection, consider the AUM in addition to other elements.

In conclusion…

Selecting the right mutual funds in India involves a careful evaluation of several critical factors, including investment objectives, risk tolerance, historical performance, consistency, manager expertise, fees, and assets under management. It is truly a blend of art and math!

Remember, investing in mutual funds offers a potent avenue for wealth growth and financial fulfilment. So, take the leap and start your investment journey today.

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