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How to choose the right mutual fund
Mutual funds have emerged as the best in terms of variety, flexibility, diversification, liquidity as well as tax benefits. Besides, through MFs investors can gain access to investment opportunities that would otherwise be unavailable to them due to limited knowledge and resources.
MFs have the capability to provide solutions to most investors' needs, however, the key is to do proper selections and have a process for monitoring. Let us see how MFs can make a difference to an investor's financial planning and its results.
Planning for long term objectives
Many people get overwhelmed by the thought of retirement and they think how will they ever save the huge money that is required to lead a peaceful and happy retired life. However, the fact is that if we save and invest regularly over a period of time, even a small sum of money can suffice.
It is a proven fact that the real power of compounding comes with time. Albert Einstein called compounding "the eighth wonder of the world" because of its amazing abilities. Essentially, compounding is the idea that one can make money on the money one has already earned. That's why, the earlier one starts saving, the more time money gets to grow.
Through mutual funds, one can set up an investment programme to build capital for retirement years. Besides, it is an ideal vehicle to practice asset allocation and rebalancing thereby maintaining the right level of risk at all times.
It is important to know that determination and maintaining the right level of risk tolerance can go a long way in ensuring the success of an investment plan. Besides, it helps in customising fund category allocations and suitable fund selections. There are certain broad guidelines to determine the risk tolerance. These are:
Be realistic with regard to volatility. One needs to seriously consider the effect of potential downside loss as well as potential upside gain.
Determine a "comfort level" i.e. if one is not confident with a particular level of risk tolerance, then select a different level.
Regardless of the level of risk tolerance, one should adhere to the principles of effective diversification i.e. the allocation of investment assets among different fund categories to achieve a variety of distinct risk/reward objectives and a reduction in overall portfolio risk.
It helps to reassess risk tolerance every year. The risk tolerance may change due to either major adjustment in return objectives or to a realization that an existing risk tolerance is inappropriate for one's current situation.
Market cap of a company signifies its market value, which is equal to the total number of shares outstanding multiplied by the current stock price. The market cap has a role to play in the kind of returns the stock might deliver and the risk or volatility that one may have to encounter while achieving those returns.
For example, large companies are usually more stable during the turbulent periods and the mid cap and small cap companies are more vulnerable.
As regards the allocation to each segment, there cannot be a standard combination applicable to all kinds of investors. Each one of us has different risk profile, time horizon and investment objectives.
Besides, while deciding on the allocation, one has to keep in mind the fact whether the allocation is being done for an existing investor or for a new investor. While for an existing investor, the allocation that already exists has to be considered, for a new investor the right way to begin is by considering funds that invest predominantly in large cap stocks. The exposure to mid and small caps can be enhanced over a period of time. (Also read - How to reduce risk while investing?)
It is always advisable to take help of professionals to decide the allocation as well as select the appropriate funds. However, investors themselves have an important role to play in this process.
All award-winning funds may not be suitable for everyone
Many investors feel that a simple way to invest in mutual funds is to just keep investing in award winning funds. First of all, it is important to understand that more than the awards; it is the methodology to choose winners that is more relevant.
A rating firm generally elaborates on the criteria for deciding the winners i.e. consistent performance, risk adjusted returns, total returns and protection of capital. Each of these factors is very important and has its significance for different categories of funds.
Besides, each of these factors has varying degree of significance for different kinds of investors. For example, consistent return really focuses on risk. If someone is afraid of negative returns, consistency will be a more important measure than total return i.e. growth in NAV as well as dividend received.
A fund can have very impressive total returns overtime, but can be very volatile and tough for a risk averse investor. (Also read - 7 investment tips to improve your returns)
Therefore, all the award winning funds in different categories may not be suitable for every one. Typically, when one has to select funds, the first step should be to consider personal goals and objectives. Investors need to decide which element they value the most and then prioritize the other criteria.
Once one knows what one is looking for, one should go about selecting the funds according to the asset allocation. Most investors need just a few funds, carefully picked, watched and managed over period of time.
Evaluate Portfolio performance
It is important to evaluate the performance of the portfolio on an on-going basis. The following factors are important in this process:
Consider long-term track record rather than short-term performance. It is important because long-term track record moderates the effects which unusually good or bad short-term performance can have on a fund's track record. Besides, longer-term track record compensates for the effects of a fund manager's particular investment style.
Evaluate the track record against similar funds. Success in managing a small or in a fund focusing on a particular segment of the market cannot be relied upon as an evidence of anticipated performance in managing a large or a broad based fund.
Discipline in investment approach is an important factor as the pressure to perform can make a fund manager susceptible to have an urge to change tracks in terms of stock selection as well as investment strategy.
The objective should be to differentiate investment skill of the fund manager from luck and to identify those funds with the greatest potential of future success.
The author is CEO, Wiseinvest Advisors Pvt. Ltd. He can be reached at firstname.lastname@example.org
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