MUTUAL FUND INVESTING 101
Higher returns usually come with higher risk. All mutual fund investments involve taking on some risk. It’s important that you go into any mutual fund investment with a full understanding of the risks involved. Liquid funds have the lowest returns and the lowest risks, while small and mid cap funds offer the potential for higher returns but also come with higher risk. For example, liquid mutual funds’ average returns of 7.6% have been similar to fixed deposits but with a slightly higher annual range of returns (4.2 to 9.4%). By comparison, small & mid cap mutual funds returns’ have averaged 13.6% but have a much wider range – the worst year was a loss of 49.3% while the best year was a gain of 131.4%. For the chance to get higher returns over the long term, investors have historically had to put up with bigger fluctuations in value over the short term.
|%||Savings Bank Rate||1yr FD Rate||Liquid MF||Debt MF||Large Cap MF||Small & Mid Cap MF|
Note: Data for March ending financial years from March 2007 to March 2018
Source: CRISIL – AMFI MF Performance Indices, April 2018
But some risk may be needed to beat inflation. Inflation averaged 7.4% for the period in the above table. As such, real returns (after inflation) were much lower – real returns were negative in the case of savings accounts, and only barely positive for fixed deposits and liquid mutual funds. Real returns were reasonable for large cap mutual funds (3.9%) and small & mid cap mutual funds (6.2%). Although inflation is low currently (3%), this is something to keep in mind.
Be aware of taxes. Equity linked mutual funds have the most favorable capital gains tax treatment. Short term capital gains (holding period of less than 1 year) are taxed at 15%, while long term capital gains are taxed at 10%. For liquid and debt mutual funds, short term capital gains (holding period of less than 3 years) are taxed at the investor’s tax slab, which is similar to the taxation of interest income from savings and fixed deposit accounts. However, for holding periods longer than 3 years, liquid and debt mutual funds capital gains are taxed at 20% with an indexation benefit – that is, only real returns post inflation are taxed at 20%. As such, liquid and debt mutual funds are generally more tax efficient compared to bank fixed deposits for holding periods longer than 3 years for investors in higher tax brackets. In addition, unlike interest income from savings and fixed deposits, there is no TDS (tax deduction at source) in case of mutual funds.
A longer time horizon usually helps. You have a better chance of capturing the higher expected returns from equity related mutual funds, if you are invested in them for a longer period of time. For example, if you held equity mutual funds for a period of five years, their average returns would have beat savings account rates in all five year periods for the data mentioned above. And if you extended your holding period to seven years, large cap equity mutual fund average returns would have been higher than debt mutual funds for all seven year periods. Separately, a longer time horizon leads to a lower effective tax rate because of compounding and tax deferral, all else being equal.
Diversify across assets and time. Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called “diversification,” can be neatly summed up as, “Don’t put all your eggs in one basket.” Mutual funds offer diversified exposure to different asset classes like stocks and fixed income.
You can further diversify your investments across asset classes. For example, you may want to earn a higher return than liquid mutual funds but may not be comfortable with losing 33% of your assets in one year if you invest in large cap equity mutual funds. If you put 50% of your assets in liquid mutual funds, and 50% into large cap equity mutual funds, your expected return of 9.5% would handily beat inflation, and your worst case annual loss would only be 14.4% (based on the data mentioned above).
Investors also protect themselves from the risk of investing all their money at the wrong time (think January 2008 for investing into a small cap equity fund) by following a consistent pattern of adding new money to their investments over long periods of time – that is, by following a systematic investment plan (SIP).
*Mutual fund investments are subject to market risks. Please read the scheme information and other related documents carefully before investing.