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Investing in Mutual Funds: Picking the Right Mutual Fund

There are currently close to 1000 mutual funds being sold in India. With a few simple steps you will know the mutual funds that it makes sense for you to buy.

1. Knowing your basics

Before you start to find the right mutual fund for yourself, obviously you have to know what a mutual fund is, how it works, its advantages and disadvantages, and so on. If you still do not have a clear understanding of mutual funds, we recommend you to go through our Mutual funds section again.

2. Plan

Before you know which mutual fund to pick, you will need to know what you want out of it. If not, it would be like buying a car, without knowing what you want to use it for (family transport, off-road racing, cross-country, cruising, or even just to look good). Our 'Knowing Yourself' section would set you in the right direction in planning and setting goals, determining your risk tolerance, time horizon and even how to stick to your goals. Of these, probably the most important thing you have to determine is your time horizon. The longer your time horizon, the more risks you can take.

The bottom line is that you need to have a plan before you can achieve your plan with a mutual fund.

3. Screening

With a solid plan in place, its time to narrow your choices. Use your investment time horizon, risk tolerance, cash flow requirements, etc., to perform this screening. For example, if you know that you have a short investment horizon, then you have to throw out all the mutual funds that are classified as high risk (in our fund selector, risk is viewed as a function of asset class risk.) The higher the risk ratings value of a fund, the higher the risk.

Now that you have screened out all the mutual funds that do not fit with your plans, you should have a more manageable size of mutual funds to look at and compare. If not, your plans are probably too general and need to be more specific (yes, you've guessed it, go back to step 2).

4. Compare and Contrast

Past performance is usually one of the most commonly used criteria for comparing between mutual funds. However, past performance is probably one of the most overrated indicators of how successful a mutual fund would perform in the future. Even the banks and fund houses tell you in their offer documents that "Past performance is not an indicator of future results." (They are required by the SEBI to write this, but sometimes it's funny how they would print this just after the part where they tell you why their mutual fund has been the best performing).

Does this mean that we should totally disregard past performance? No. Past performance is still one of the best measures of how good a fund is. However, we should look at past performance together with other non-quantitative factors like

  1. The investment philosophy of the fund manager,
  2. Whether or not the industry invested in is growing or stagnating,
  3. How the objectives of the mutual fund match your own, and so on.

Don't just look at past performance alone.

After doing your comparisons, you should have managed to narrow your list of suitable mutual funds even further.

5. Cost and Expenses

Perhaps one of the most commonly quoted guides to picking the right mutual fund is to simply buy the cheapest. The rationale behind this is that the lower your costs are, the lower your returns need to be in order for you to make a profit (profit=returns - cost).

How solid is this argument? Well, all other things remaining equal, it's quite good. Think of it this way. No one can ever accurately predict what a mutual fund is going to make in the coming year. However, one thing that everyone knows for sure is exactly how much the mutual fund charges in terms of initial entry loads, exit loads and annual management fees. So, it makes sense to put lower loads and annual fees as one of your first few key criteria. What you save in terms of loads and fees is the additional return you get.

By this time, you should be in a pretty good position to decide the fund that is "right" for you!

Next : Picking the fund manager