Mutual fund for dummies

2 September, 2007

Ranjit Pillai started his career just three years ago in BPO outfit. He is already concerned about his savings and retirement. Reason: he gets to read reams of paper detailing the retirement problems concerning the baby boomers in the USA. However, he can’t decide how to start investing and how to take care of it. “I am a bit a worried because I don’t want any setbacks in the beginning. What if I call it quits,” he asks.

Pillai would be happy to know that even India can boast of professional fund houses, which will help people like him with their investments. In fact, this is one industry that has made giant leaps in the last decade. However, greenhorns like Pillai would find it difficult to pick the right fund as well as scheme since there is a problem of plenty. However, we would like to make it easier for people like him.

To begin with, let us see what is a mutual fund. A mutual fund is an investment vehicle, which takes money from several investors, and invests that money in stock markets or debt markets or both. The choice of investment will depend on the objective of the fund. In short, a mutual fund allow you to invest in equity or debt market without investing directly in them. It also takes up the job of managing the money for a professional fee.

Now, why should you take the help of a fund house? Can’t you invest directly? Well there are a host of reasons why mutual fund is a better choice.

Professional management: One, a mutual fund offer you the service of a professional management. For example, imagine you are investing in the stock market. Chances are that most of us don’t have the skill to pick good stocks or time track them. On the other, when you invest through a mutual fund, you get the service of a fund manager, who is an investment expert. He will take care of your investment.

Diversified portfolio: Two, you will get a diversified portfolio, which will considerably decrease your risk. Remember the old adage of not putting all eggs in one basket. In a diversified portfolio, even if some picks in your portfolio fails to perform, the others may check the erosion in the value of the portfolio.

Consider the following scenario. Assume that someone bought Rs 10,000 worth Infosys and the stock fell 30% next month. That means the value of the portfolio also dropped 30%. Alternatively, imagine someone bought 10 different stocks worth Rs 10,000. He also bought Infosys stock, but only for Rs 1,000. Suppose if other stocks stayed at the same level, even after the Infosys fall his portfolio would be still worth Rs 9,700. That is, the portfolio depreciated only by 3%. That is the advantage of diversification.

Small beginning: The third advantage with a mutual fund is that it allows you to start with small investments. Something younger people can take advantage of. For example, if you want to buy a portfolio of blue chips of modest size, you should at least have a few lakhs of rupees. A mutual fund give you the same portfolio for meager investment of Rs 1,000-5,000. A mutual fund can do that because it collects money from many people and it has a large corpus.

Liquidity: An open-ended mutual fund allows you to take your money whenever you want. Most of them will mail your redemption proceeds within a few days.

Tax breaks: you don’t have to pay any taxes on dividends issued by mutual funds. You also have the advantage of capital gains taxation. Tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. Investments up to Rs 10,000 will qualify for tax rebate.

But are they with out any disadvantages? Sure, even they have some drawbacks. Mutual fund investments are risky. Unlike your fixed deposit at the bank, the value of investment in a mutual fund can fall. Also, there is no protection of capital in them. Unlike a bank deposit, where your deposits up to Rs 1 lakh is insured, investments in mutual funds are not insured. They are also not backed by any government guaranty. Don’t be disheartened. There are enough checks in place and most reputed fund houses have good performance records.

Another flip side is that your gains can be limited in a mutual fund. For example, in our earlier example, if Infosys jumped by 30%, the person who directly invested in the stock would have made 30% profits. But the other person who went for diversification would make only 3%. The same can happen in a mutual fund, as even they have diversified portfolio. Redemption pressures can also cap gains in a mutual fund, as the fund manager will be forced to sell despite the prospects of the stock.