Earning money through investments in securities has been there for a long time. Still, recently, with so many different investment options, people are keen on earning additional income via investments in stocks, bonds, securities, cryptocurrency, etcetera, rather than the traditional approach of interest payments from fixed deposits and savings accounts in banks. With these ever-increasing investment options, the risk associated is also on the rise, yet investors are ready to take the gamble for the chance of earning higher returns.
What are mutual funds?
Investment vehicles that consolidate investors’ money and invest in money market instruments like equity shares, debt securities, bonds, etcetera are known as mutual funds. These mutual funds are managed by professional portfolio managers, who aim to derive capital gains and income for the investors by allocating their money to suitable assets in the fund. Mutual funds allow their investors, be it small or individual, access to professionally managed portfolios comprising stocks, bonds, and other securities. Each investor owns shares that denote their proportional ownership of the fund and participate proportionally in the losses and gains of the fund.
Read More About What is Mutual Fund?
How do mutual funds work?
A mutual fund is a company as well as an investment. When an investor invests in a mutual fund, they buy a share of that company and its assets. A mutual fund invests the consolidated amount in stocks of listed companies, corporate bonds, short-term money-market instruments, government bonds, and other forms of securities. A portfolio is created to align with the investment objectives of the investor. Hence, an equity mutual fund invests predominantly in stocks and a debt fund in bonds.
A portfolio manager or a fund manager makes decisions of buying, selling, and in general, managing securities daily, keeping in tune with the mutual fund’s investment objective. Each unit, sometimes called a share, of a mutual fund is bought by an investor. The price of each such unit is called the Net Asset Value (NAV). The assets are invested in the portfolio of the fund. Most managers also own some shares of the fund.
The portfolio manager decides the portfolio allocation depending on the mutual fund’s investment objective. These managers may employ analysts to select investments or for market research. An accountant is employed to calculate the NAV of the fund and the value of the portfolio daily that determines whether the value of the shares increases or decreases.
Also, sometimes mutual funds have one or more attorneys and compliance officers to keep in tune with the government regulations.
How do mutual funds make money?
Mutual funds can increase their value by making profitable investments and from dividends or interest amounts payable from the underlying securities. Investors owning units of mutual funds benefit from this as the mutual fund’s NAV increases, and also through distributions.
Investors typically earn through mutual funds by-
- Dividends paid on the stocks of the funds and through the interest payments from the bonds in the portfolio. Almost all the earnings of the fund are paid out to the investors of the fund in the form of a distribution. The funds also offer the option of reinvestment of the earnings and thereby owning more shares.
- Capital gains through selling off of securities of the fund after an increment in the said securities values. Most funds pass on the capital gains to their investors through a distribution.
- Investors can also sell their shares of a mutual fund. When the fund’s holdings increase in value and are not sold by the portfolio manager, the fund’s shares also witness an increase in value. A shareholder can sell their shares, thereby earning a profit.
How to maximise the profits of a mutual fund?
We can also maximise the profits from a mutual fund if we strategise well.
Diversification of the portfolio
Different types of mutual funds generate a wide range of returns depending on the underlying securities of the fund, the decisions made by the fund managers, the category of the funds, the market condition, as well as the economic conditions. There are asset classes that are negatively correlated to one another.
Economic and geopolitical uncertainties affect the performance of mutual funds also. Gold funds perform well under these situations, but equity funds falter. In a rising interest rate regime, long-term debt funds do not perform as well as short-term debt funds, and vice versa.
Hence, a diversified portfolio entailing funds from different asset classes and fund houses generates returns that are risk-adjusted and are based on the investor’s risk tolerance, investment horizon, and financial goals.
Over-diversification of portfolios, as well as the concentration of investment in one category of funds or asset class, should be avoided.
SIP Mutual Funds
Systematic Investment Plan or SIP allows investing a predetermined amount spread over a period of time in regular intervals- daily, weekly, monthly, quarterly, half-yearly, yearly, etc. This regular investment allows for a financial discipline to be developed. SIPs allow for a lower minimum amount of investment than other mutual funds. Thus, even though investing lower amounts, one stands a chance of gaining higher returns.
The regular and automated investments of a SIP allows for cost averaging by purchasing mutual fund units at lower NAVs when the market is declining. This averages the investment cost and thereby mitigates the need to monitor the market and also to time the investments.
Choosing Direct Plans over Regular Plans
The fund houses of direct plans do not incur distribution charges and hence have a lower expense ratio than the regular plans. Therefore, the savings from the distribution charges remain invested in the fund, which owing to the compounding effect, generates returns of their own. Hence, direct plans offer a higher return than regular plans. Though the difference is not substantial in the short term as the effect of compounding becomes prominent in the long term.
Investing for a longer period
When investments are made for longer periods, maybe five years or more, then it is easier to ride out the market fluctuations. Drastic decisions taken during market fluctuations might result in substantial losses. Having a sound and well-researched course of action and smartly dealing with risks is the key to long-lasting wealth generation.
Mutual funds are a great way to earn money but are also a great way of losing it. When investing in a mutual fund, careful considerations of the risks, the investment amount, the fund type, and also the stability or volatility of the fund need to be done. Also, reviewing the mutual fund periodically would assist in assessing the performance of the fund and help in timely switching to some other funds if the existing one underperforms constantly.
FAQs
Do Mutual Funds Create Wealth?
Yes, mutual funds can create wealth over the long term by providing diversified exposure to a range of assets, which can lead to capital appreciation and income generation. They are managed by professional fund managers who aim to achieve specific investment objectives.
Are Mutual Funds Really Profitable?
Mutual funds can be profitable, but the profitability depends on various factors such as the type of mutual fund, market conditions, management fees, and the duration of investment. Historically, equity mutual funds have provided substantial returns over the long term, while bond and money market funds offer more stability with lower returns.
Is SIP 100% Safe?
No, Systematic Investment Plans (SIPs) are not 100% safe as they are subject to market risks. However, SIPs can help mitigate risks by averaging out the cost of investment over time and reducing the impact of market volatility. They are a disciplined way of investing and can be less risky compared to lump-sum investments.
