A strategy for investing in mutual funds

A fund’s investment philosophy, consistency, levels of diversification, returns over market cycles are the yardsticks for mutual fund investment especially in volatile markets.

Any mutual fund investing has to be synchronized with our investment goals and risk tolerance. Each fund has an investment style. The investment style helps identify whether a fund's risk-return profile matches ours. Fund’s prospectus shows its investment objective, how it would be achieved and it’s risk-return positioning. A risk-taker - who wouldn't have sleepless nights if the net asset value (NAV) fluctuates a lot, may consider a mid-cap equity fund. These may deliver higher returns but are likely to be more volatile than large-cap funds.  Funds with higher rates of return may take risks that are beyond our risk tolerance level. For example, a fund that invests primarily in stocks whose prices may change quickly – like initial public offerings or real estate stocks – will usually be riskier than other types of funds. Generally, fund whose returns are volatile have higher investment risk. Sometimes pinpointing the investment style of a fund is not easy as its worded loosely like “long-term growth of capital” or “to generate regular income” as such a loose definition gives the fund manager ability to maneuver the investment strategy. We can spot such a change by periodically tracking the fund’s portfolio.

Once the decision on the type of funds that suit us is taken, its time to look at their past performance. While past performance does not necessarily guarantee future returns, it can tell how volatile a fund has been. We can examine the consistency of returns over 3-5 years against a benchmark index and other funds in the same category to judge the superior performance of the fund. This helps avoiding one-season wonders.

For those of us who are already invested in mutual funds, it is necessary to make sure that our funds from different fund families do not hold the same stocks. This will have an impact on the level of diversification we are trying to achieve by investing in different funds. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk. Most financial planners suggest a minimum of three mutual funds for an investible surplus of at least Rs 1,00,000-Rs 1,50,000. These would typically be a stock fund, a bond fund, and a money market fund. Such segregation will protect part of the corpus from volatile stock markets.

Finally, index funds alone have relative predictability. They provide precisely the market's return with lesser costs decade after decade. Investing in index fund funds and balanced funds through SIP can protect us from volatility and help us partake in higher returns generated by stock markets.

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