3 Phases of Investments in Mutual Funds

Create, preserve, redeem... No, we are not talking of the cosmic life-cycle but the mantra to manage your mutual fund investments.

If you are a newbie investor taking the first shaky steps into the world of mutual funds, you might think that your job ends with choosing the right fund to bet on. The money then compounds miraculously, leaving you with a neat pile when you need it the most. However, this is far from the truth.

The Trinity concept comes in handy when explaining the phases of mutual fund investments and how all three phases play a significant part in helping you achieve your objective.

From creation comes life, and from destruction comes re-creation. Taking a divine cue from Brahma, the creator, Vishnu, the preserver, and Shiva, the destroyer, you must pay equal attention to the creation of your mutual fund portfolios, preservation of the corpus and finally the redemption and deployment of the redeemed funds.

Let’s take a look at the three stages in the life-cycle of a mutual fund portfolio.

MUTUAL FUND INVESTMENT GUIDE:

Creating the right portfolio 

A job well begun is half-done. But before you start buying schemes to build a portfolio, you have to pause and ask yourself two questions. The answers to these questions will define the contours of your portfolio. The questions are:

Why am I saving money? There ought to be specific objectives for which you are saving money in mutual funds. These objectives are called goals in investment parlance.

Setting up goals such as paying for your college fees, buying a car or house, planning for your children’s higher education, your retirement, etc, will help keep you focused. The goal will further help identify the investment options and to decide the time frame required to achieve the goal.

How much risk am I willing to take? Once the goal is defined, you have to assess your risk profile to understand the level of risk you are comfortable with. Age, employability, nature of job, family background, capital base and regularity of income are some of the factors considered while measuring the risk profile.

Choosing the right assets: Once the goals and risk profile are defined, you have to decide on the right assets to invest in. Mutual funds offer an array of options to investors, including equity, fixed income, gold and overseas equity. Depending on your goals and risk profile, select the right mix of assets.

For instance, investors with a reasonable risk appetite could consider investing in equity mutual funds while retirees with low to medium risk profile could go for balanced debt-oriented and short-term debt funds.

You might want to create multiple portfolios, one for each goal. In this case, the time period will determine the asset mix. For instance, if you are saving for your son’s higher education and want the money in five years, you might want to park the money in a mix of equity and debt funds.

The future value of the corpus depends on the right asset allocation. Each category has its own risk return profile. The equity mutual fund categories — sector, thematic, large-cap, mid- and small-cap, and multi-cap funds — are high-risk high-return products suitable for investors with high risk profile and for long-term financial goals. Fixed income categories such as liquid, ultra-short term, short-term income, long-term income, credit opportunities and gilt funds are suitable for investors with low to medium risk appetite.

A 30-year-old investor with a high risk profile can allocate 70-80 per cent of his long-term portfolio into equity diversified funds with the rest in balanced and debt funds. A fund portfolio should ideally comprise 5-7 funds. Your asset allocation between debt and equity should be in line with your risk appetite. Any mismatch or imbalance will lead to exposure to higher risk or inability to achieve the corpus within the desired time frame.

Selecting the right schemes: It is important to select the right schemes within the preferred category, based on the consistency in generating good returns (measured by rolling return), risk-return trade-off and expense ratio.

Mode of investment: Investors can consider either lump sum or Systematic Investment Plan (SIP) to invest in mutual funds. Lump sum investment is suitable while investing in debt oriented funds. Lump sum investment in equity oriented mutual funds may not be a wise idea since it is not easy to time the market.

If the market declines significantly after a lump sum investment, there could be sizeable erosion in the capital invested.

SIP is a more disciplined approach through which investors can invest small sums at regular intervals. It inculcates the habit of saving and building wealth for the long term. SIPs work well irrespective of market conditions and help reduce risk through rupee cost averaging. (SIPs enable purchase of more units when prices are down and vice versa. This is called rupee cost averaging).

Power of compounding 

By investing in mutual funds, one can reap the benefits of compounding, that is, the gains made are reinvested, thus compounding the gains. Compounding works well over the long term.

The chart below shows the growth of SIP investments in Sensex across time-frames. It is seen that SIP investment for a longer time-frame achieved better results than for shorter periods.

There are other value added services offered by fund houses, such as Systematic Transfer Plan (STP), Value averaging investment plan (VIP), smart SIP and Power SIP, which help investors phase their MF investments according to their need.

Preserving the corpus 

In the second phase of the investment cycle, the investor has to find a way to enhance returns while preserving the amount invested.

Step up investment: You can step up the investment with rise in the income level. This can be done either through lump sum investments or by topping up SIPs. 

Another important aspect to consider is that one should not stop or sell the SIP investment during market downturns; this will make you miss out on rupee cost averaging.

Review and rebalance: Over time, the defined asset allocation structure tends to change due to the outperformance or underperformance of the underlying assets in the portfolio. It is mandatory for investors to realign and get back to the original asset allocation. This will help keep the portfolio on track and achieve the goal in the desired time frame. Also, there are some circumstances under which you need to rebalance the fund portfolio. The risk level of an investor can change due to increasing age, change in income flow, etc. Asset allocation has to be realigned based on the altered conditions.

At times, some asset classes can generate lower returns due to macro or regulatory changes; this can impact the objective of the portfolio. A case in point is the fall in small saving rates in the recent period. Investors have to carefully realign the portfolio without changing the risk level of the portfolio in such situations.

Redeem to reinvest 

The end is always the beginning. This principle is true for MF portfolios too as you cannot take it easy after redeeming your funds. In most instances, the funds have to be redeployed so that they can continue to generate returns, albeit at a lower rate.