Mutual funds rank high as an efficient investment avenue for investors. Over the years, they have helped new investors by offering inflation-adjusted returns in both short and long-term investment horizons. This is evident by the consistent increase in the inflows into the mutual fund industry. But there are certain aspects to consider before going full steam ahead into investing in mutual funds.
In this article, we list the top five things you must know before you invest in mutual funds.
- Assessing your risk appetite
Mutual funds can provide better returns than other traditional investment instruments, but it comes with a specific degree of risk. Investors assume credit risk, liquidity risk and market risk in exchange of higher returns. Hence, it is crucial to know how much risk you are willing to take to earn better returns. You can do that by assessing your current income, liabilities, job stability, health and other such factors.
- Making the right asset allocation
Currently, inflation rates are between 3% and 5%. So, if you are considering investing more than 50% in debt funds, it could lead to negative real returns. This is because interest rates and bond prices share an inverse relationship. It makes sense to start with a higher percentage of equity mutual funds allocation if you are below 30. You can then gradually move on to 75:25 investment ratio between equity and debts and later on to 50:50 and 25:75 as you near your retirement age.
- Understanding all the options
Most mutual funds come with three options – growth, dividend payout and dividend reinvestment. It can be a good idea to spend some time ascertaining the pros and cons of each of these options to decide where to invest money. For instance, if you need a steady income, you can choose the dividend option. If you are looking at building wealth, consider growth options.
- Knowing the tax implications
It is essential to understand the holding periods of different mutual funds and how they are taxed. For example, equity-linked mutual fund category such as ELSS mutual funds qualify for a deduction under Section 80C for Rs.1.5 lakh. On redemption, long-term capital gains are taxable at 10% after exhausting the limit of Rs.1 lakh.
- Knowing when to book profits
It is crucial to remain focused on the financial goal you wish to achieve. If you are building a corpus for a long-term goal, refrain from booking temporary or short-term gains. If you keep booking your profits, it could result in capital gains tax and transaction costs; both of which could affect your returns in the long run.
As a new investor, you can gain more knowledge by reading about what is a mutual fund and making mutual fund investments a part of your financial planning. If you decide to invest in mutual funds via SIPs, remember to review it monthly or quarterly. By doing so, you can get a clearer picture of whether your investments are approaching towards the financial goal you set for yourself or not.