Start investing with Mutual Funds – Your guide to Diversification

While researching a particular company’s fundamentals can be time consuming and may not allow a new investor to quickly enter the market, investing in mutual funds can offer a quick entry into the market while you continue your research. Today, I would like to point out the most essential attributes to look for before you start investing in a mutual fund.

What is a mutual fund?

A mutual fund aims to pool money from several investors for the purpose of investing it in various financial instruments. Investments are distributed across equities, bonds, debt markets and other types of assets. Each fund is operated by a fund manager who allocates this pool of money and attempt to offer a high return on investment.

Why should you choose to start with a mutual fund?

Getting used to reading company annual reports and its financials and completing a thorough research before investing requires several hours of hard work and you may find yourself overwhelmed with the idea of investing. Value investing heavily relies on research and while you continue learning, you must also keep in mind, that each day you are not invested, is a day lost for your money to provide any returns. For this reason, mutual funds are a quick way to enter the market, allowing your savings to grow while you learn. Over time, your ability to identify multi-bagger stocks will improve, and during this time, your money will also be working for you!

How do you pick a mutual fund?

There are tons of funds available to begin with, which only adds to the growing confusion of a novice investor. I’m here to simplify this for you with some easy do’s and don’ts that can help you quickly start that process of investing 🙂

DON’Ts:

1.  DON’T rely heavily on Fund Rankings

Most of the beginner investors start with this approach by simply looking for the best ranked fund available on the market at present. For example, here’s a list of the fund rankings in USA by US News and here’s another list for top ranking funds in India. While these ranks help us understand a funds performance over the years, this information alone should not be used to make a decision.

The moment a fund starts getting more recognition and appears on one of these lists, many retail investors start investing more money into these funds. The drawback of this approach is that it becomes extremely difficult for a fund manager to manage this newly arrived moola. When the stock market is overvalued, retail investors refrain from entering the market and buying any more stock, however, for a fund manager, even during times of overvaluation, trading must continue. This is because the law does not allow fund managers to hold on to more than a certain percentage of cash. This can lead to a compromised choice of investments on the part of the fund manager and the overall fund may or may not return the same growth.

2.  Historical gains DON’T imply Future gains

After reviewing the rankings, we often tend to look at the past performance of the fund. If the fund shows great returns over the last 1 or 3 years, we are soon attracted to bet on it. However, relying only on the historical returns and expecting the same returns in the future can result in bad decisions. Short term gains cannot be used as the only indicator for your investments and you must dive deeper to ascertain your money is in the right place.

DO’s:

1.  Look at The BIG Picture

This is a follow up to my point earlier about short term gains. When reviewing a funds performance, look for the consistency of growth in the fund for the past 10 years. How has it performed as compared to its benchmark index? Has it shown mostly positive returns during this entire period? Was it able to beat the market?

Let’s look at a simple example for Vanguard PrimeCap fund

vanguard
Source: US News

From the chart above, we can clearly see that the Vanguard PrimeCap Fund has consistently outperformed the S&P 500. Not only has it outperformed its benchmark index, but also ranked high consistently. Long term consistent growth is key to selecting the right fund.

2.  Look for the RIGHT Fund Managers

Fund managers are more important than the fund itself. A funds success or failure is in the hands of the fund manager, and if you invest in a fund where the fund manager was successful only in few cases but not many, you may be making the wrong choice. Look for fund managers who show consistency in performance in handling various funds.

3.  Understand the Fund Holdings

In order to diversify your investment, it is extremely important to choose a fund that allocates funds across various assets. You may only be interested in technology stocks, and there are many funds only focused on investing in the technology sector, but if you wish to start, do so with a diversified portfolio. This not only diversifies your investments, but also reduce your exposure to risk. Here’s the asset allocation for the example we used before

vang_asset
Source: US News

It is clear by looking at this that the majority of the funds(96.1%) are allocated across equities. While this fund has shown great growth, it may not be your choice for a diversified portfolio. However, this also means a diversified equity portfolio. Thus, if an investor only wishes to invest in equity markets and does not believe in debt markets, this could offer a good diversification across several stocks in itself.

Such type of funds are usually deemed high risk, due to heavy reliance on equity asset allocation.

4.  Understand the Costs and Fees

Investing in a mutual fund has its associated costs and fees that must be understood thoroughly to avoid paying too much. For the example of Vanguard we used previously, you can find the fees here. We do not wish to select funds that charge a heavy price to its investors. An expense ratio of 1% means that 1% of the funds assets will be used to cover the funds expenses annually. There will also be a purchase fee in order to buy into a fund that must be clearly understood before investing. For example, if you invest $1,000, a purchase fee of $25 may be deducted from your amount, thereby making your starting investment as $975.

Now that you clearly understand that do’s and don’ts, the question still remains, what should be your ideal startup fund?

For long term growth, select a fund with the following characteristics:

  • Medium to Moderately High Risk fund
  • Diversified Asset Allocation
  • Equity holdings in Large Cap companies. If you do not understand market capitalization you can read my previous post here
  • Low costs and fees
  • Consistent growth and performance of fund manager

I hope this article will help you in making an informed decision towards your goals of investing. My goal is to provide these tools in their simplest form, without having to pay exorbitant amounts of money to gain this knowledge. In return, I appreciate your feedback and hope you can follow me for my latest updates to keep you informed.

Be Frugal, Be Smart, Be Rich!

Disclosure: I do not promote any of the funds I listed above and used them only for the purpose of educating my readers. I am not being paid by any of the funds or company’s to provide this information.

16 thoughts on “Start investing with Mutual Funds – Your guide to Diversification

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