Basics of Mutual Fund Investment
Created on 26 Oct 2020
Wraps up in 5 Min
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Updated on 18 Aug 2022
Usually, when a person gets their monthly salary in their bank account, they keep some amount of the salary as savings for future needs or an emergency in their savings account, which in turn gives them 4% of the amount as returns.
However, this is considered as a poor method of savings because, in India, the inflation rate goes up to 4-5%, which means that the money in the savings account, will lose its value every year and the savings remain the same as before.
Because of this reason, people invest their money in different ways, so their money does not lose its value (due to constant fluctuating inflammation prices).
In India, people mostly follow the path of four types of investments; Savings accounts (Lower risk with no time restrictions and you will get 4-5% of the return.), Fixed Deposit (FD is a very low-risk investment with a fixed time. This means that the money you put in this deposit is not accessible till a certain pre-decided time which is why many get a higher return around 6-8%).
Gold and Jewellery (This is a high-risk investment since gold value fluctuates rapidly and almost every time within the market, therefore, not promising a stable or high rate of return), and Real Estate (to invest in real estate, one needs large capital and its return is also volatile).
And if some people wish to take a higher risk to get a higher return, then they invest in the stock market (it is always advisable to have some basic knowledge of the stock market before investing in it).
Regardless of which route one takes to invest their money, there are always some constant factors that one must take care of while investing their money.
These three things are:
1. Return- How much return/ profit you will get from your investment. The return should be more than the inflation rate; otherwise, there is no benefit to the investment.
2. Risk- It is best to study and weigh all possible risks before making a decision. If you invest in the wrong market, then you might have to bear a loss.
3. Time- For how much time you need to invest your money to get a higher profit.
So, the basic rule of the market is that if you want higher returns, then you have to take higher risks and invest money for a longer period.
In every investment, there should be diversification( Investing in different markets, if one of the markets crashes then other market's return will nullify your loss).
However, most of the Indian population is the middle class which means that they cannot afford to invest in different markets due to their financial situations as investing in different markets requires lots of money.
So, what is the alternative to this? How can a normal middle-class person invest in different markets?
The answer lies with Mutual Funds. You must have heard about mutual funds on television, in newspapers, or from your peers and colleagues who often discuss investing in mutual funds.
Did you know that SEBI recently recategorized and rationalized the mutual funds' schemes?! Click here to know more.
Let us dive into the basics of mutual fund investment.
What is a Mutual Fund?
A mutual fund is a collection of stocks or bonds that an organization or an Asset Management Company (AMC) buys on your behalf.
The AMC takes the money from different investors and pools that money together to invest in different sectors to get a higher return with the help of a market expert. The AMC then distributes the investment and keeps some amount of the portion collected from the investors in the form of a unit (called units), and the investor is called the unit holder of that mutual fund.
Investors can invest their money in the stock/bond market instead of directly investing in them through mutual funds.
To understand mutual funds let's walk you through an example;
Suppose, as a common man you wish to travel by Ola, Uber, or a local taxi service from one city to another, but the cost of traveling alone in a taxi costs a lot. In these situations, people use the pooling/sharing option to reduce their traveling costs.
Pooling or Sharing means that people find other people who wish to travel to the same destination from the same location. Such people contribute their share of money and pay the collective amount to the taxi driver. This means they all had to contribute less amount of money to reach the same destination, and thus, they saved their money.
Similarly, if you wish to invest in the stock market but the price of the shares are too high, as a common man it is very hard to invest your hard earnings in the stock market when knowing that investing money in the stock market without any prior knowledge can be risky and it could cause you to lose money.
In this situation, mutual funds investment acts as the sharing/pooling option, saving the individual from spending a hefty amount of money, by distributing it across various investment areas.
How do Mutual Funds work?
In mutual fund investment, many people contribute their money and give it to the AMC to further invest their share. The AMC invests money in different markets which give higher returns. This investment is made through the help of a market expert hired by AMC.
The AMC then allot units to its investors according to the Net present value (NAV) of the mutual funds.
Suppose, you invest Rs 5,000 in mutual funds, and the NAV of the mutual fund is Rs 50, then the AMC will allot 100 units to the investors of that mutual fund scheme.
If the price of that mutual fund unit goes up to Rs 55 per unit, then the investor's total return for that year will be 10% because investors bought that unit at Rs 50. Now, the investors may sell their units to get profits, or they can hold it for a long time to get a higher return.
But does the organization or AMC do this for people without charging them anything? You are right; nothing comes without a cost in this world!
An AMC, with the help of a market expert, invests the investors' money in different sectors to get a higher return. When the AMC earns profits, they do not distribute all the profits to their investors; they keep some small portion of the profit as a fee for the market expert. The fees they charged is called the expense ratio.
It is advisable to invest in those mutual funds which take a lower expense ratio. For the long-term investors, it may not affect them much, but if you are a trader who buys and purchases mutual funds frequently, this can cause a huge loss of money because traders have to pay an expense ratio every time they trade in the market.
Mutual fund investments have gained popularity for the last few years because of the immense benefits it has served to people of all groups (varying economic backgrounds and genders).
It is an investment that improves if one familiarises themselves with the scheme one wishes to invest in, in the future. No trade or benefit can be advantageous if the reader, investor, or an individual shy away from doing their research and gain knowledge to avoid scams in any field at all, and the same goes for mutual funds as well.
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