Being spoilt for choice isn’t always a good thing. Studies have shown that the best decisions are made when there are fewer options to choose from. The paradox of choice is what supermarkets thrive on. They give you so many options to pick from that you end up buying more than what you need–often just to try things out.
On a similar vein, the mutual fund investor is also spoilt for choice. But when it comes to fund investing, an investor cannot afford to “try” funds out. There is no room for error here. The performance of your investment is directly linked to the goals you are investing for. It is your hard-earned money that you are putting into a fund, which is why picking the right fund is of utmost importance.
But choosing the right fund is not easy. Even seasoned investors struggle when making a choice. It is understandable for a new investor to be overwhelmed by the entire process. There are just way too many funds to choose from. That said, choosing your first mutual fund has more to do with your own self than the fund options in front of you.
When you are faced with the decision of choosing a mutual fund, ask yourself the following questions and base your decision on the answers you come up with.
What am I investing for?
You will make better investment decisions if you are investing for a specific purpose or goal. This goal could be the purchase of a new car or house, saving for your child’s education or a vacation abroad. Even investing in a mutual fund just to be able to save and earn better returns than a savings account or fixed deposit can be a goal. With a definite purpose in mind, you can make an informed choice.
What is my investment horizon?
On a very broad level, the longer you have to invest, the more risks you can take. If your investment horizon is just a few years away, you should probably take fewer investment risks. This is why the number of years is an important metric to consider when choosing a mutual fund.
Is my goal negotiable or not?
A vacation abroad can be a negotiable goal in the sense that if you don’t have the adequate amount, you can push the vacation further by a few months. But something like a child’s college education is a non-negotiable goal. You have to pay the fees at a specific time and that is something you cannot delay.
Once you have the answers to these three questions, you will be able to decide on the type of fund you need to invest in. For non-negotiable short-term goals, you should opt for debt mutual funds. If the goal is non-negotiable but a few years away, you can begin investing in an equity fund and gradually book profits as you come nearer to your goal. For negotiable long-term goals, you can consider equity funds because they are best placed to give you higher returns. If the goal is negotiable but short-term, a balanced fund would be the best option.
Once you have figured out the type of mutual fund you need to invest in–equity, debt or balanced–you should choose a fund that has a long history of doing well over different market cycles. This means that a fund that has weathered different economic conditions in the past would be a more sound bet than a new fund that doesn’t have a history to speak of. Of course, past performance does not guarantee future returns, but it is a good indicator when making a choice.
A simple way to do this is look at the top performing funds of a category over various time periods like 1 year, 3 years, 5 years and 10 years. Among these funds, choose the fund that appears in the lists for most time periods. You can also take the help of a mutual fund expert to give you fund suggestions based on your goals and investment horizon.
This is how you can simplify the process of choosing a mutual fund. Remember to be honest to yourself when you answer the questions mentioned above. You will make a better choice when you know your investment purpose and goal clearly.