Most of us feel that our money flows through our hands just like water; there is no end to expenses and usually very little left for anything else. Occasionally, you may ask yourself, ‘How do I save for a rainy day?’ ‘What will I do if anything unfortunate happens to my loved ones or me where hospitalization is required?’ ‘How do I build enough wealth to be financially comfortable and fulfill my financial goals?’
These questions imply that every rupee you earn or have should be allocated towards four purposes:
While savings will help you deal with a rainy day and insurance will protect you in case of an unfortunate situation, mutual funds may help you fulfill your financial goals and build wealth.
Your investment risk profile:
Before exploring mutual funds, you must assess your investment risk profile; in other words, are you comfortable taking risks? How much risk should you take? To assess your risk profile, consider your current wealth, age, income, number of dependents, and comfort with risk. For instance, if you are young, just starting out in life, have no dependents, and are earning well, you can take on a higher level of investment risk than someone who is middle-aged and has a number of financial responsibilities to fulfill.
Your asset allocation
Based on your risk profile, you can decide on your asset allocation; this is simply deciding how much you should invest in equity and how much in debt. For instance, an investor with a low-risk profile can invest a small amount in equity (say 20%) and a higher amount in debt (80%) since equity carries higher risk than debt. For an investor with a medium-risk profile, the debt-to-equity ratio can be about 60%:40%, while for an investor with a high-risk profile, the debt-to-equity ratio can be about 20%:80%.
Using mutual funds:
Now that you have your asset allocation in place, let’s examine the various categories of mutual funds in which you can invest based on your asset allocation:
Equity funds – These mutual funds invest in equity stocks of companies across different sectors/industries and market capitalizations. These funds look for companies that are expected to grow at a faster rate than the overall market. While these funds carry high risk since they are associated with equity investing, if you remain invested for the long term, the risk is reduced over time and you have the opportunity to earn higher potential returns. These funds are suitable for fulfilling financial goals such as accumulation of sufficient wealth for a comfortable retirement. For example: Diversified Funds, Focused Funds, Index Funds and Sectoral Funds.
Debt funds – These funds invest in government securities, certificates of deposits, corporate bonds, and money market instruments. The fund manager trades in debt securities in the debt markets based on changes in interest rates. When interest rates fall, the prices of existing debt securities rise, and vice versa. These funds carry lower risk than equity funds because they invest in debt; they are suitable for fulfilling medium-term financial goals such as buying a home, wanting to go on a vacation or buying a new car in the next 2-3 years. For example: Income Funds, GILT Funds, Fixed Maturity Plans and Liquid Funds
Hybrid funds – These funds invest a portion of their portfolio in equity and the rest in debt. Some hybrid funds are equity oriented (i.e. they invest about 65% or more in equity) while some are debt oriented (i.e. they invest about 65% or more in debt securities). The investment risk associated with these funds depends on their orientation; while equity-oriented funds carry higher risk, debt-oriented funds carry lower risk. These funds are suitable for investors who want to combine their debt and equity investments within one investment option for convenience and for those wishing to fulfill medium- to long-term financial goals such as children’s education, marriage or foreign holidays after 5 years. For example: Balanced Funds and Monthly Income Plans.
Building an investment portfolio starts with assessing your investment risk profile and ends with selecting suitable investments based on your asset allocation.
Before you invest, consult a financial advisor who can recommend funds after assessing your risk profile.
Based on your risk profile, you can decide your asset allocation.