A mutual fund is a pool of money deposited by thousands of investors, collected by a mutual fund company, commonly known as a fund house. The fund house then uses the pooled money to buy stocks, bonds, commodities, etc. Each fund house has various schemes. For example, a scheme can be stocks-oriented, bond-oriented, or commodities-oriented, or it can be combined. The decision to buy the underlying securities depends on the nature of the scheme. The purchased products are called holdings or portfolios of that particular fund. Like every class has a class teacher, every scheme has a manager called a fund manager. The fund manager is an experienced professional, and his/her job is to make investment decisions to generate profit from investments. This profit is then shared with the investors as returns. The investors get returns in proportion to the money they have invested.
An investor can start his investment journey in mutual funds by depositing money in one go. This is called a lump sum investment. The other way is by investing regularly – every month, every quarter, etc. This method is called a Systematic Investment Plan (SIP) or SIP. An investor can start investments with as little as ₹100 per month in SIP mode, so it’s easy on the pocket. After the investment, all investors are allotted units. The number of units depends on the amount of the investment. Each unit has a value called Net Asset Value or NAV. A simplified explanation of the NAV is that it is the market value of the total holdings of the scheme divided by the total number of units issued. NAV is calculated on a daily basis, as the market value of holdings changes daily.
An investor may not know which stocks to buy, when to buy stocks, or when to buy bonds, so he may make a wrong decision and incur losses. But, in mutual funds, a professional fund manager with several years of experience makes decisions.
There are several benefits to investing in mutual funds via an SIP. A striking feature of SIPs is the power of compounding. In simple words, compounding helps investors get a return on both the initial and continuing investments. Over a long period of time, this can result in substantial wealth creation with a small initial investment. Another important feature of SIPs is rupee-cost averaging. This helps average the cost per unit of investment over time. When market prices are high, the investor gets fewer units, but the same investment fetches more units when the prices fall. This, in the long run, lowers overall investment costs.
In most mutual funds, an investor can easily withdraw money in an emergency. The withdrawal process is called redemption. The units held by an investor are normally encashed at the NAV of the day of application if the application is submitted by 2.30 pm. The withdrawal amount gets credited to the investor’s account within one, two or three days depending on the type of funds. This makes mutual fund investments highly liquid. Some mutual funds have a longer redemption period – you will know which ones these are when you sign up to buy the fund.
An investor has to pay taxes on profit or capital gains made in mutual fund transactions. There are two types of capital gains taxes on mutual fund profits – short-term capital gains tax or STCG and long-term capital gains tax or LTCG. The tax rate depends on the type of mutual fund and the duration of the investment period.
Let us understand this with a simple example. Imagine three friends having ₹150 each to invest. Instead of buying one stock each, friends decide to pool their money. Now they have ₹450. One of the friends understood the nuances of the market and was entrusted with investing the pooled money. He bought 5 shares of Company A (₹50 each) and 2 bonds (₹100 each). The friend who invested money on behalf of two others is like the fund manager of a mutual fund scheme. The mix of investments – shares of Company A and 2 bonds – is the portfolio or the holdings. Since the portfolio has stocks and bonds, it helps reduce risk by not keeping all the eggs in one basket. Three days after the investment, the stock price of A rises to ₹60, while there is no change in bond price. Thus, the total value of holdings goes up to ₹500. There are three friends, so the total number of units becomes 3. The NAV on the day, thus, is 500/3 = ₹166 nearly. This is a simplified example of how NAV is calculated.
Let us now look at the benefits of investing in mutual funds:
- Diversification: Spreading money across various assets lowers risk
- Experts make investment decisions
- Funds cater to different risk levels and financial goals
- Even small investors can create wealth with small investments
- High liquidity
- Low-cost investment
- For SIPs, the Power of compounding and Rupee cost averaging
Mutual funds can be a powerful tool for wealth creation with small, regular investments over a long period of time. However, mutual fund investments also carry market-related risks like all market-related investments. Therefore, investing only in schemes aligned with your financial goals and risk appetite is important. If one is not confident about choosing the right mutual fund schemes, he can get advice from a SEBI-registered investment advisor.
