How to choose the right mutual fund

Mutual funds have emerged as the best in terms of variety, flexibility, diversification, liquidity as well as tax benefits. Besides, through MFs investors can gain access to investment opportunities that would otherwise be unavailable to them due to limited knowledge and resources.

MFs have the capability to provide solutions to most investors' needs, however, the key is to do proper selections and have a process for monitoring. Let us see how MFs can make a difference to an investor's financial planning and its results.

Planning for long term objectives

Many people get overwhelmed by the thought of retirement and they think how will they ever save the huge money that is required to lead a peaceful and happy retired life. However, the fact is that if we save and invest regularly over a period of time, even a small sum of money can suffice.

It is a proven fact that the real power of compounding comes with time. Albert Einstein called compounding "the eighth wonder of the world" because of its amazing abilities. Essentially, compounding is the idea that one can make money on the money one has already earned. That's why, the earlier one starts saving, the more time money gets to grow.

Through mutual funds, one can set up an investment programme to build capital for retirement years. Besides, it is an ideal vehicle to practice asset allocation and rebalancing thereby maintaining the right level of risk at all times.

It is important to know that determination and maintaining the right level of risk tolerance can go a long way in ensuring the success of an investment plan. Besides, it helps in customising fund category allocations and suitable fund selections. There are certain broad guidelines to determine the risk tolerance. These are:

Be realistic with regard to volatility. One needs to seriously consider the effect of potential downside loss as well as potential upside gain.

Determine a "comfort level" i.e. if one is not confident with a particular level of risk tolerance, then select a different level.

Regardless of the level of risk tolerance, one should adhere to the principles of effective diversification i.e. the allocation of investment assets among different fund categories to achieve a variety of distinct risk/reward objectives and a reduction in overall portfolio risk.

It helps to reassess risk tolerance every year. The risk tolerance may change due to either major adjustment in return objectives or to a realization that an existing risk tolerance is inappropriate for one's current situation.

Market cap of a company signifies its market value, which is equal to the total number of shares outstanding multiplied by the current stock price. The market cap has a role to play in the kind of returns the stock might deliver and the risk or volatility that one may have to encounter while achieving those returns.

For example, large companies are usually more stable during the turbulent periods and the mid cap and small cap companies are more vulnerable.

As regards the allocation to each segment, there cannot be a standard combination applicable to all kinds of investors. Each one of us has different risk profile, time horizon and investment objectives.

Besides, while deciding on the allocation, one has to keep in mind the fact whether the allocation is being done for an existing investor or for a new investor. While for an existing investor, the allocation that already exists has to be considered, for a new investor the right way to begin is by considering funds that invest predominantly in large cap stocks. The exposure to mid and small caps can be enhanced over a period of time.

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Tags: mutual funds, liquidity, investors, gain, investment, retirement, long term, planning, market cap, risk profile, portfolio, invest funds, large cap, middle cap, small cap