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A BEGINNERS GUIDE TO MUTUAL FUNDS

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Mutual Funds - Your First Fund
For first time investors, it is important to choose a fund that can provide reasonable returns with moderate risk

Useful, simple to understand and easy to execute - these are desirable qualities that your First fund investments should have. For beginners, these requirements are generally best satisfied by tax-saving funds and balanced funds. Here's why. Most First time investors in mutual funds have erstwhile invested in traditional investment products consisting of bank deposits, public provident fund or PPF, post office savings and other fixed-income investments. Hence it makes sense to diversify your investment portfolio into other asset classes like equity. While you may not have the time and the skill sets to choose stocks and invest directly into equity, the professional set up of mutual funds can be used to invest in equity oriented mutual funds. There are two types of funds that beginners may look at - Tax-Saving Funds and Balanced Funds. Read on too know more about them. 

Tax Savings Funds: are also called as Equity-Linked Savings Scheme or ELSS funds. They are diversified equity funds eligible for tax exemptions under Section 80C of the Income Tax Act, 1961. Under this section, you can avail tax exemption on investment of up to Rs.1 lakh per financial year in a set of prescribed investments, one of which is ELSS. Since these are equity funds, it is desirable to invest in them for the long-term (at least with a more than 5 years investment horizon). This long-term imperative is enforced to some extent as these funds have a 3-year lock-in period as per current tax laws. A longer holding period helps to considerably lower the sharp variation in returns (volatility) typically associated with equity funds. The tax-break also acts as a natural boost to returns. 

Balanced Funds: are also called equity oriented hybrid funds and combine equity and debt investments in a certain ratio (skewed towards equity). In order to maintain this ratio, the fund manager typically disinvests from the asset class (equity or debt) that has gained more and invests in the one that has gained less. 

As a result, gains made in equity are transferred to debt or vice-versa. A big advantage of balanced funds is that while they capture the gains of the equity market to a large extent, they are relatively less riskier than pure equity funds. This is because the debt component helps to cushion the downside in the returns, when the market cycle changes. Hence, Balanced funds generally fall less sharply than pure equity funds and help to protect the gains made when equity markets were positive.

SUMMARY

A beginner’s first mutual fund should be useful, simple to understand and easy to execute. Tax saving funds (ELSS) and equity oriented hybrid funds (Balanced funds) are generally a good option to start investing in.

 

1 Balanced Funds need to maintain an average 65% holding in equity over the financial year to qualify as an equity fund under current tax laws

Next To Come: How To Select Funds