Mutual Funds Explained: A Beginner's Guide to Investing

Investments play a vital role in establishing financial security and reaching long-term objectives. By allocating your money to different investment options, you enable it to grow over time, potentially surpassing inflation and boosting your wealth. Investments also offer the advantage of diversification, which spreads risk and minimises the effects of market fluctuations on your overall financial portfolio. Moreover, wise investing can generate passive income, aid in retirement planning, and help you achieve significant milestones like purchasing a home, funding education, or launching a business. Ultimately, investments are essential for building a stable and prosperous financial future.

Mutual funds are regarded as one of the top investment options for several key reasons. Let’s dive deep into this type of investment and mutual fund overview. Let's begin by knowing what mutual fund basics are.

Introduction to mutual funds:

A mutual fund is a collective pool of money gathered from investors, which is then invested in various securities such as stocks or bonds. Each share in the mutual fund represents a proportional stake in the fund’s overall portfolio, meaning that the more shares you own, the larger your ownership in the fund. There are thousands of mutual funds available, offering a wide range of investment options. You can choose funds that invest in a diverse mix of large companies, small companies, specific geographic regions, or even particular sectors of the economy.

Suitability

Mutual funds can be a smart choice for investors at various stages of their investment journey. However, it's crucial to understand that the value of a mutual fund depends on the specific assets it holds rather than the fund itself. These funds can invest in various assets, such as bonds, stocks, commodities, or a combination of different asset classes. Before investing in a mutual fund, it's essential to research and understand the risks associated with the fund's underlying assets.

Mutual fund investments are suitable for both beginners and seasoned investors. Beginners benefit from their diversification, while experienced investors can use them to target specific sectors or areas they believe have strong growth potential.

Differences between mutual funds

One of the key differences between mutual funds is whether they follow an active or passive investment strategy.

1.Active mutual funds

Active mutual funds are managed by professional investors aiming to outperform a market index, such as the S&P 500. In an active stock fund, the fund manager and a team of analysts carefully select which stocks to include and in what proportions to achieve the highest possible returns. Similarly, active bond funds seek to outperform bond indices through strategic management.

However, this approach is challenging, and actively managed funds often struggle to match, let alone beat, the performance of the index they aim to surpass. Additionally, active funds typically come with higher fees (often around 1% of the fund’s assets) to cover the costs of professional management, which further reduces investors' returns.

2.Passive mutual funds

Passive mutual funds, on the other hand, are designed to mirror the performance of a market index. These funds do not require a costly investment team because they aim not to outperform the index but to match it. As a result, passive funds can charge very low fees, or sometimes none at all, allowing investors to retain more of their returns.

Though passive funds may seem straightforward and perhaps less exciting, they have consistently outperformed actively managed funds over the long term. While some active funds may outshine their benchmarks over short periods, very few manage to do so consistently over time.

Types of mutual funds

With so many mutual funds to choose from, it can be overwhelming to navigate through them all. Let’s explore some of the most popular types of funds.

1.Stock funds

Stock funds invest in corporate stocks but can vary greatly in their strategies. Some focus on established companies that pay dividends, while others prioritise growth and the potential for price appreciation. Some funds specialise in specific industries, sectors, or geographic regions.

2.Bond funds

Bond funds invest in various forms of debt, with risk levels that can differ significantly from one fund to another. Some bond funds invest in relatively safe government-issued bonds, while others target “junk” bonds that offer higher potential returns but come with increased risk. Reading the prospectus before investing is important to fully understanding the risks involved.

3.Money Market funds

Money market funds are typically low-risk and provide a modest return slightly above that of a traditional savings account. These funds invest in high-quality, short-term debt issued by companies and governments.

4.Index funds

Index funds have become increasingly popular due to their simplicity and low-cost structure. These funds track the performance of an index, such as the S&P 500, and are known for keeping costs low. Research has shown that this passive investment approach often outperforms active management over long periods in most cases.

Tips for beginners investing in mutual funds

Beginners guide to mutual funds

For those new to mutual fund investing, here are a few seasoned tips:

1. Start with index funds: For investment for beginners, start with index funds, which are mutual funds or exchange-traded funds that aim to replicate the performance of a market index like Sensex or Nifty.

2. Assess your risk appetite: Once you're comfortable with index funds, you can explore large-cap, mid-cap, or small-cap mutual funds based on your risk tolerance.

3. Monitor diversified funds: Unlike index funds, which require minimal oversight, diversified funds need regular monitoring. Experts suggest actively managing and taking corrective action if a fund's performance falls below its benchmark.

4. Consider SIPs: Systematic Investment Plans (SIPs) are ideal for beginners. SIPs allow you to start investing with as little as ₹500 per month, benefiting from the growth of the Indian stock market over time.

5. Limit your portfolio: Avoid over-diversifying by investing in too many funds. Experts advise holding 4-5 funds in your portfolio, with a balanced mix of small-cap, mid-cap, flexi-cap, and large-cap funds. For large-cap exposure, opting for index funds is preferable.

Choosing the right mutual fund

Last but not least, let’s look at how to choose a mutual fund.

For those starting with mutual funds, selecting the right mutual fund can feel overwhelming, given the wide range of options available. Start by considering whether a fund’s investment objectives align with your long-term financial goals. For beginners early in their careers, a low-cost S&P 500 index fund is often a good starting point. More experienced investors or those interested in actively managed funds will need to dig deeper. It’s important to understand the fund’s overall strategy and investment philosophy, as well as who the portfolio managers are and how they make investment decisions on your behalf.

Ultimately, the fund’s performance is key, so take the time to understand the mutual fund factors driving its long-term success and whether those factors are likely to persist. Additionally, be mindful of the fees associated with investing in a fund. Remember, if two funds perform equally well, the one with lower fees will yield better returns for investors.

Mutual funds offer a convenient way to invest in a diversified portfolio of securities with a relatively low minimum investment. However, it's important to read the fund's prospectus and investment fundamentals before investing to understand the associated risks fully.