Mutual fund investing can be intimidating, particularly if you are new to it. With thousands of funds and confusing financial terminology on every corner, how do you select the most appropriate one for you? Relax – selecting the right mutual fund doesn’t have to be so difficult. What you’ll learn in this book is how to go about making intelligent choices in line with your financial objectives.
Why it is Important to Select the Correct Mutual Fund
Imagine a basket that contains various investments such as stocks and bonds. When you purchase a mutual fund, your investment gets combined with the investments of other investors, and skilled fund managers invest the collected amount in diversified securities. In this manner, you have exposure to a diversified portfolio without having to select individual stocks on your own.
But the thing is – all mutual funds are not the same. Each fund has varying goals, levels of risk, and investment approaches. Investing in the wrong fund will lead you to miss your financial targets or expose yourself to more risk than you are willing to take.
Also Read: When Should You Sell a Mutual Fund? A Complete Guide
Step 1: Define Your Financial Goals Clearly
Even before you look at any mutual fund, ask yourself: What am I investing for?
Your investment objectives will drive everything else – which fund to invest in, the number of years you would invest, and how much risk to take. Some typical investment objectives are as follows:
- Short-term objectives (1-3 years): Emergency fund, holiday, or purchasing an gadget
- Medium-term objectives (3-7 years): House down payment, wedding costs
- Long-term objectives (7+ years): Retirement, children’s education, building wealth
Various goals require different kinds of funds. For short-term goals, you would prefer safer ones, such as liquid funds or debt funds. For long-term wealth creation, equity funds may be better suited in spite of their short-term fluctuations.
Step 2: Understand Your Risk Tolerance
How much loss can you bear without worrying?
Risk and reward go hand in hand when it comes to investing. Typically, money that can deliver higher returns also involves greater risk. Knowing your risk tolerance enables you to select funds with which you feel comfortable.
- Conservative investors want safe returns and typically select debt funds or balanced funds. These kinds of funds invest in bonds and other fixed-income instruments.
- Moderate investors can tolerate some fluctuation in hopes of increased growth. They may opt for balanced funds or large-cap equity funds.
- Aggressive investors are comfortable with large market fluctuations if it will bring higher returns in the long run. They tend to go for mid-cap, small-cap, or sectoral funds.
Keep in mind, your risk tolerance is not entirely a matter of personality – it also has to do with your age, your level of income stability, and how much time you have to achieve your goals.
Also Read: How to Invest in Mutual Funds in India – Step-by-Step Guide for Beginners
Step 3: Think About Your Investment Time Horizon
How much time do you have to invest your money?
Time is your greatest asset in investing. The more time you can commit to investing, the more you can take advantage of compounding and weather market volatility.[6]
- In less than 3 years: Hold only debt funds, liquid funds, or ultra-short-term funds. These are safe and allow easy withdrawal of your money.
- For 3-7 years: Look at hybrid funds that invest both in stocks and bonds. These provide some growth upside while keeping risk in check.
- For 7+ years: Equity funds are great options. Even with short-term fluctuations, they have traditionally generated good returns in the longer run.
Step 4: Know the Different Types of Mutual Funds
Knowing the primary mutual fund categories will enable you to make better decisions:
Equity Funds
These invest primarily in stocks and are suitable for long-term goals:
- Large-cap funds: Invest in big, established companies (lower risk)
- Mid-cap funds: Focus on medium-sized companies (moderate risk)
- Small-cap funds: Target smaller companies (higher risk, higher potential returns)
- Multi-cap or Flexi-cap funds: Invest across different company sizes
Debt Funds
These invest in bonds and fixed-income securities:
- Liquid funds: For very short-term needs (up to 91 days)
- Short-term funds: For 1-3 year goals
- Long-term debt funds: For longer time horizons
Hybrid Funds
These combine both stocks and bonds:
- Balanced funds: Equal mix of equity and debt
- Aggressive hybrid: More equity, less debt
- Conservative hybrid: More debt, less equity
Also Read: Mutual Funds vs. Chit Funds: Which is Better for You?
Step 5: Examine Key Performance Factors
When considering mutual funds, don’t just look at history. Here are the key factors to consider:
Fund Performance and Consistency
See how the fund has done over various periods – 1 year, 3 years, 5 years, and since its inception. More valuable than high performance in a single year is sustainable performance over the long haul. A fund that provides stable 12% returns tends to be preferable to one that provides 20% one year and -5% the next.
Fund Manager Track Record
All investment decisions are made by the fund manager. Find out their experience, performance history with other funds, and how long they have been running this specific fund. An experienced fund manager with experience in other market cycles can be useful.
Assets Under Management (AUM)
This will tell you how much the fund holds in terms of money. Extremely tiny funds (less than ₹100 crores) may have problems with operational efficiency, while extremely large funds may be less able to make high returns because of their scale. Check for funds with sensible AUM that reflects investor faith without being too cumbersome.
Step 6: Watch Out for Costs and Fees
Each rupee you spend on fees is one less rupee earning for you.
The expense ratio is the yearly fee levied by the fund house as a percentage of your investment. For instance, if you invest ₹10,000 in a 1.5% expense ratio fund, you’ll pay ₹150 per year as fees.
These are some important points to note about costs:
- Equity funds usually have expense ratios ranging from 1-2.5%[10]
- Debt funds typically have a cost of 0.5-2%
- Index funds are the cheapest, typically below 1%
- Direct plans have a lower expense ratio compared to normal plans
Pro tip: Any 0.5% difference in expense ratio can make a considerable difference on your long-term returns because of compounding.
Also Read: SIP (Systematic Investment Plan) vs Lump Sum Investment – Which is Better for You?
Step 7: Decide Between SIP and Lumpsum Investment
You have two primary methods to invest in mutual funds:
Systematic Investment Plan (SIP)
With SIP, you invest a fixed sum at regular intervals (monthly, quarterly). Advantages are:
- Rupee cost averaging: You purchase more units when prices are low, less when high[12]
- Disciplined investing: Develops a regular saving habit[12]
- Lower entry barrier: Begin with as low as ₹500 a month[12]
- Reduces timing risk: You won’t have to worry about excellent market timing[12]
Lumpsum Investment
This involves investing a large amount at once. It works well when:
- You have a significant amount available for investment.
- Markets are undervalued or in a downturn
- You want immediate full exposure to market movements
For beginners, SIPs are often recommended because they’re easier to manage and help build investment discipline.
Step 8: Consider Tax Implications
Understanding the tax benefits and implications can help optimize your returns:
Tax-Saving Funds (ELSS)
Equity Linked Savings Schemes (ELSS) offer tax deductions up to ₹1.5 lakh annually under Section 80C. Key features:
- 3-year lock-in period (shortest among all tax-saving options)
- Potential for higher returns compared to traditional tax-saving instruments
- Long-term capital gains above ₹1.25 lakh are taxed at 12.5%
Regular Mutual Fund Taxation
- Equity funds: Long-term gains (held over 1 year) above ₹1.25 lakh taxed at 12.5%
- Debt funds: Different tax treatment based on holding period
Step 9: Build a Diversified Portfolio
Don’t put all your eggs in one basket.
Diversification means spreading your investments across different types of funds to reduce risk. A well-diversified mutual fund portfolio might include:
- Large-cap funds for stability
- Mid-cap or small-cap funds for growth potential
- Debt funds for steady income
- International funds for global exposure
- Sector funds for specific opportunities (in small amounts)
The key is to avoid over-diversification. Having too many similar funds doesn’t add value and makes your portfolio complex to manage.
Step 10: Avoid Common Mistakes
Learning what NOT to do is just as important:
Don’t Chase Last Year’s Winners
A fund that performed excellently last year might not repeat that performance. Focus on consistent long-term performance instead.
Don’t Try to Time the Market
Attempting to buy low and sell high rarely works. Stay invested for the long term and let compounding work for you.
Don’t Invest Without a Plan
Every investment should serve a specific goal. Random investing often leads to disappointing results.
Don’t Panic During Market Downturns
Market volatility is normal. Stopping your SIPs or selling during market lows often does more harm than good.
Don’t Ignore Costs
High fees can significantly eat into your returns over time. Always check the expense ratio before investing.
Getting Started: Your Action Plan
Now that you understand the key factors, here’s how to get started:
- List your financial goals with timelines and target amounts
- Assess your risk tolerance honestly
- Choose appropriate fund categories based on your goals and risk appetite
- Research specific funds within those categories
- Compare expense ratios and fund manager track records
- Start with SIPs if you’re a beginner
- Monitor and rebalance your portfolio periodically
Final Thoughts
Picking the right mutual fund isn’t necessarily about discovering the “perfect” fund – it’s about discovering funds that meet your goals, risk level, and time horizon. Begin with the fundamentals, continue educating yourself, and don’t hesitate to consult a pro when necessary.[3]
Don’t forget that successful investing is a matter of time in the market, not timing the market. The sooner you begin and the longer you continue to invest, the more likely you will be to reach your financial objectives.
Ready to start your mutual fund journey? Begin by setting a clear financial goal and doing research on funds that will help you get there. One step at a time, and you’ll be rich before you know it.
Disclaimer: This article is for educational purposes only and should not be interpreted as individual investment advice. Please consult with a qualified financial advisor prior to making investment decisions.
