List of Guidelines to Follow Before Investing in Mutual Funds

Over the last few years, the name mutual funds have become a household name and has become one of the most preferred forms of investments amongst the investor community. But the toughest part of it is making an investment decision which will help you to select the right one from the available range of funds to secure your set financial goal. One cannot always blindly go with a product which has a good track record in the past without taking into consideration other factors such as downside risk, charges and so on.

If an investor can make a right decision by picking up the right funds amidst hundreds of variants then it is a good job, but if it is a wrong one, then they are likely to lose money in big terms. Analyst's note that the key thing for an investor is to identify their investment objective, risk-taking ability and time horizon of investment before arriving at an investment plan.

Let's understand in brief about the mutual funds and its features.

What is a Mutual Fund?

A Mutual Fund is a kind of financial investment tool which is used to collect a pool of money from investors to invest in securities like equities, bonds, money market instruments and other related assets. Usually, these mutual funds will be operated by professional money managers who will allocate the fund's assets and attempt to improve gains for investors.

Key Takeaways from Mutual Funds

• Mutual Fund is a type of investment tool which has a portfolio of assets like stocks, bonds and other securities.
• These mutual funds give small and individual investors access to diversify their investment by professionally managed portfolios at a minimum price.
• An annual fee will be charged from the investors which are also known as expense ratio and some times it is also called as commissions and this factor is likely to affect the overall returns.
• Mutual funds are divided into several kinds, depending on the investment objective, nature of the scheme and structure.
• Higher the risk, higher the returns is the mantra of mutual funds.
• Diversification of investment and following up are important to ensure to get best returns.
• Asset Allocation plays a very important role to balance out the risks. An investor should park their funds between various asset classes based on their risk-taking ability. A mix of equity (riskier assets) and debt instruments (non-riskier) should be opted out to get the best out of your investment.

After understanding the meaning of mutual funds let's know the list of guidelines to follow before investing in mutual funds to reap better returns.

Assessing Risk Preference

All the investment tools have some element of risk associated with them and hence an investor needs to assess as to how much of risk are they willing to take. Identifying the risk tolerance factor in advance will come in handy to park your funds in respective instruments to fetch the desired financial gains. The key mantra in case of mutual funds is higher the risk, higher will be the returns and vice versa. 

Prepare in Advance 

Preparation well in advance plays a very important role in any kind of successful investment. If you are a beginner, then it is better to seek advice from a financial advisor for a predetermined fee or commission. If you are opting to learn and invest, then first ask yourself some insightful questions like

• What are your financial goals?
• How long should I invest for (tenure of investment)?
• Purpose of investment - retirement goal or buying house or children's education? 

Figure out the answers as this will indeed determine to help you make a relevant choice of investment you are planning to make. 

Know the Key Terms Associated with Mutual Funds

Having a basic understanding of certain specific terms which are used in the mutual fund's markets will come in handy for investors. It is better to know the meaning of keywords like standard deviation, alpha, beta, Sharpe ratio and so on. 

Standard Deviation 

The term standard deviation will measure the volatility of the returns from a mutual fund scheme over a particular period. It will inform how much the fund's return can deviate from its historical mean return of the scheme.

For Example: If a fund has a 10% average rate of return and the standard deviation of 3%, then its return will range from 7%-13%.

Alpha

Alpha in case of mutual funds refers to the excess return of a fund compared to its benchmark index.

For example: If a mutual fund scheme has an alpha of 12%, it shows that it has outperformed its benchmark by 12% during a particular period.

Beta

This term measures the fund's volatility compared to that of a benchmark. It indicates how much a fund's performance will swing compared to a benchmark.

Sharpe Ratio

This term will measure how well a fund has performed against the risk taken on it. It will be the excess of return over the risk-free return divided by the standard deviation. Higher the Sharpe Ratio will indicate the better performance of a fund which will be in proportion to the risk taken by the investor.

Understand the Types of Mutual Fund Schemes

Understanding the various types of mutual fund schemes will give you an edge to find the suitable mutual fund schemes which you are planning to invest in. Generally, mutual funds are classified into three categories and they are:

• Based on Structure
• Investment Objective
• Nature Of Schemes

Optimum Allocation of Assets

Determining the asset allocation as to how you will divide your investment between various asset classes be it share, bonds, government securities, real estate, gold and so on is the next prominent process. Asset allocation forms the product of your risk preference, investment horizon and financial goals.

Fund House

Before zeroing in on a particular scheme you should pick a fund house on which you have enough faith to park your hard-earned money. Try to figure out those fund houses which will have a strong presence in the financial markets and provides schemes which have a reasonable and consistent track record.

Select Appropriate Schemes

After determining the asset allocation, now start looking out for schemes which will help you to achieve your desired investment objective. Before picking up schemes, do take a glance at their expense ratio, performance, fund managers and so on. Please do keep in mind your ability to take risk, financial goals while zeroing on the schemes.

Mutual Fund Portfolio

Now create a mutual fund portfolio which will help you to monitor and manage your investments efficiently and smoothly. Diversify your investments broadly and create a portfolio which will help you to achieve your desired financial goals.

Understand the Tax Rules

The tax factor can eat into your profits and hence it is important to keep the tax rules in mind and assess how much of your earnings will attract tax when you redeem your investment. Some of the mutual fund schemes do offer tax benefits like equity-linked savings schemes (ELSS), you can always pick them up to save your earnings from tax.

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About the Author

Archana is a Content Writer at GoodReturns. She has been writing articles related to investment planning and personal finance for more than two years.