How to Choose Right Mutual Fund? Should You Chose The Right Fund Or The Best Fund?

People often talk about the best mutual funds to invest in, the top-performing mutual funds of the year or the top mutual funds from each AMC. But is it right to actually invest in those funds because they are the best funds? Are the best funds the right funds for all? Shouldn’t they be appropriate for a given situation to a given investor? So does that mean the top funds and best performing funds lists are of no use? Well, no one is wrong when they write articles on the top funds and best funds, they are just merely communicating about the fund’s performance. When one is investing in a fund they need to understand which fund suits their situation. Choosing a mutual fund depends on multiple factors.

Investment Horizon

The time horizon (the time period) of investment is very important while choosing a fund to invest. Choice of mutual funds is mainly based on the time horizon. If the investment horizon in between 1 month to 3 years then debt funds are the best to invest. This is because they do not fluctuate much and are less risky compared to equity funds. If the horizon is between 3-5 years then hybrid funds are the best choice. For any horizon greater than 5 years then equity funds are the best because the time period is enough for the returns to absorb the volatility.

Risk Tolerance

Mutual funds can also be chosen based on risk tolerance. A risk-averse person is better with debt funds which are least risky ones, hence the return is also low. A person with a medium appetite to risk can stick to balanced funds. A person with more risk tolerance can go with equity funds and the risk is paid off with equal return. Equity funds have the highest return among all funds.

Other Factors

There are other factors that also need to be taken into consideration while choosing mutual funds. The age of a person and how far or close is he/she to retirement also determines the risk level of the person, in turn, deciding what type of fund they can choose. A person in the early 20’s should be taking more risk as he/she has fewer responsibilities on their shoulders and can take risk and bear loss if any. Hence the portfolio can have maximum equity. A person who is in the mid-’50s can’t afford to take a lot of risks. Hence the portfolio can have only 40-50% equity.

The experience of a person in the market also determines the choice of funds. A new entrant in the market will be scared seeing a 5% loss in the portfolio and hence will not be willing to take the risk even if he/she can afford to. But a person with 10 years into the market will not panic with a 5% drop in the portfolio and they understand the market well and hence don’t panic and will be willing to take the risk if needed.

Another factor that determines fund choice the importance of the goal. If the goal is critical like child’s education and the person started investing early then he can afford to take risks and invest in equity funds. But if the person started investing just 3 years before the goal has to be realized he cannot afford to take a risk and will have to stick to debt funds.

Every Investor is Unique

Every investor is unique and hence the way of choosing funds is unique to every investor. Mutual funds are a way to enter financial markets for the inexperienced. First-time investors with long years investment horizon (7 years and more), investing for critical goals can go with equity for best returns. Even if their risk appetite is low, equity will be the best choice as they have the advantage of the time horizon. If they are still worried about the risk in their portfolio, large-cap funds are the best choice for them as they are the least risky equity funds.

But if the investor is investing for the first time and has a short investment horizon (1-3 years) and are investing for critical goals can invest in short term bond funds which are the least risky funds. They give better returns and are tax-efficient than FDs.

Hybrid funds are highly recommended for first-time investors who want to test the financial markets. They come with better returns than debt funds with medium risk and also have the benefits from equity and debt in their portfolio. An investment horizon of 3-5 years is ideal for these funds. Once the investor is comfortable with investing in these funds he can move to more risky equity funds.

Debt and equity both have funds with different levels of risk. Liquid, short and medium-term funds are the least risky funds in the debt category. For equity, the risk is the most in small-cap followed by the mid-cap, multi-cap and large-cap funds. Each has an investment horizon of 5+ years. But the longer the investor stays invested the better the returns. But how long is long enough?

Have an Exit Strategy

Every business comes up with an exit plan. Hence it is important for each individual investor to have a plan too. What is more dangerous than loss-making is the greediness to earn more than required. Markets take unexpected turns for unexpected events and one might end up losing all that has been earned in the process. Hence it’s better to have a plan for redeeming the investments. Have a target amount or target return percentage set before the investment is done. Once the target is reached redeeming the investments is better than seeing it all vanish within moments. If setting a target percentage is difficult then stick to what the market expects to be a good return. Somewhere around 15-20% return is considered good from a mutual fund investment in India. Don’t be greedy and stick to the target always.

Understand that each investor is unique and choose the right fund than the best fund. Pick funds based on your age, investment horizon, and risk tolerance. What might be best for one person may not be the best for others