Mutual Fund Investment Benefits

People who have invested in mutual funds for a long period of time know that they are the best investment options to achieve financial goals. Let us discuss the major benefits of investing in mutual funds.

Asset Allocation

The most important success factor in financial goals is asset allocation. Asset allocation is linked to your risk profile and financial objectives. For example, for young investors, equity is the best asset class. As per a common asset allocation heuristic, a 30 year old investor should have 70% allocation to equity and 30% allocation to debt. A 50 year old investor should have 50% allocation to equity and 50% debt.

There are various asset types like equity, debt, gold, real estate etc. Within each asset category, there are several sub-categories. Mutual fund products span the entire spectrum of almost all asset categories and sub-categories. With mutual funds, you can manage your asset allocation with the passage of time in the most efficient way.

Mutual funds can also help you rebalance your asset allocation in an efficient manner. Over the passage of time the optimal asset allocation profile of the investor changes. With mutual funds, you can switch from equity fund to debt fund or vice versa with a simple transaction, as opposed to more complex transactions where you have to sell stocks and buy bonds or vice versa. Mutual funds also offer investors the flexibility of investing in small weekly/ monthly/ quarterly installments (popularly known as SIP) out of their regular savings, with only a one time effort. Mutual funds also offer investors to switch between asset types in a systematic way (weekly, monthly, quarterly etc.) through Systematic Transfer Plans (STP), without having investors to worry about price levels, timings etc.

Professional Management

Investing in stocks may be more glamorous than investing in mutual funds, but for most retail investors, investing in mutual funds gives better results. This is because mutual funds are managed by professional fund managers who have much more experience and knowledge of investing than average retail investors

Mutual funds incur a cost to manage a scheme which is charged as fee to investors (in form of expense ratios). However, since mutual fund works on the concept of a pool of money from many investors, the cost is spread out over a large investor base and so the average cost to an individual investor is quite small. 

Diversification

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example.

Let us assume that, you invest in a bank stock. If the bank makes a quarterly loss, for whatever reason, then the share price of the bank will go down. This is a company specific risk. Even during the quarter, if the RBI, hikes interest rates, for whatever reason, the share price of banks (including the one, you have invested in) are likely to go down. This is a sector specific risk. Both types of risks, company risk or sector risk, are unsystematic risks.

Let us now assume that the Nifty, the index of the largest market cap stocks in India, of which your bank stock is also a part of, goes up or down by 3% in a day. If Nifty goes down by 3%, your bank stock, is also likely to go down in price. This is because your bank stock is part of the stock market, and therefore subject to market sentiments and risk. This is known as systematic risks or market risk.

We have no control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks; how? Let us assume, in addition to investing in the bank stock, you also invest in a pharmaceutical stock. If the pharmaceutical company that, you invested in, makes a profit in the quarter in which your bank stock made a loss, then the share price of the pharmaceutical company will rise, which may fully or partially, cancel out the loss made in the banking stock. Also, the pharmaceutical sector is unrelated to banking sector and therefore, even if the entire banking sector is affected due to an event, the pharmaceutical sector may not be affected. Therefore, by adding, a pharmaceutical stock to your portfolio, you will be able to reduce your overall portfolio risks.

Mutual funds pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio. By investing, just Rs 5,000 in a diversified equity mutual fund, you can get diversification benefits that may have required at least few lakhs if you had invested directly in equity shares.

Suitability for a variety of financial goals

Mutual funds are suitable for a wide variety of financial goals and risk profiles. Equity funds are ideal for long term financial goals. Balanced funds are great long term investment options for investors having moderate risk profiles. Long term debt funds are good investment options for medium term financial goals, while short term debt funds are good investment options for short term financial goals.

Mutual funds provide great solutions for even very short term (few days, weeks or months) financial goals. Liquid funds are much better vehicle for parking your short term funds for a few days to few weeks or even months, compared to your savings bank account. Liquid fund returns, which are based on money market rates, are much higher than your savings bank interest rate. Ultra-short term debt funds offer investing solutions for periods ranging from a few months up to a year. The returns of ultra-short term debt funds are usually higher than liquid funds. One can also consider arbitrage funds for parking short term funds. Arbitrage funds, on an historical basis, have matched liquid fund returns, but are more tax efficient than liquid and ultra-short term debt funds.