Tips for selecting a mutual fund

Here are some important things to keep in mind while selecting a mutual fund.

1. Make sure you are clear on why you are investing in a mutual fund. There are roughly two main reasons. (i) Investment + for tax saving for claiming deduction under section 80C and (ii) Purely investing purpose.
   
   
2. Choosing between Growth and Dividend options : Nearly each mutual fund comes in two options : Growth and Dividend. In the growth option you get back your entire money after you sell or redeem all units of the mutual fund. In the dividend option, you keep getting periodic (usually yearly) dividend on your investment. i.e. the mutual fund periodically pays out a sum depending on its performance in that year. Dividend option is good for those who are looking for yearly income. Dividends are currently tax free. Choosing between growth and dividend options is purely a matter of ones own personal requirements.
   
   
3. How much risk to take ? You have to decide how much risk you want to take on this investment. Lets talk about three categories of risk : low risk, medium risk and high risk. I would advice the following type of people to stick with low risk options. (i) People who are new to stock market and have no or little experience in dealing with shares / stocks. This is because any risk you take without having an above average understanding of the stock market will NOT be a calculated risk. (ii) People for whom this investment is going to be a significant portion of the total investments and savings they currently have. Please bear in mind that "taking high risk amounts to higher returns" is a myth or a fallacy. Risk itself means your investment can shrink.
   
   
4. Selecting for Tax deduction purpose : Not all mutual funds are eligible for deductions under 80C. How to identify tax saving mutual funds ? Any such mutual funds usually clearly mention this. Also such mutual funds have a lock in period of 3 years.
   
   
5. Choosing a Low risk option : In order to minimise risk it is important that the mutual fund you pick has a well-diversified portfolio. Which means, if you look at the portfolio of the mutual fund, then it must not have a major percentage of its investment in a single stock. How does one find out about the portfolio of a mutual fund ? Here is one possible way (i) Go to Moneycontrol.com (ii) In the search options click on "NAV" and type the name or part of the name of the mutual fund in the search box and search. (iii) A list of matching names will appear on the screen. Click on the mutual fund you are looking for. On the page that will appear, scroll down and you will see "Portfolio Analysis". There will be a list of companies and next to each of them you will see the percentage of the total amount that the mutual fund has invested in that particular company. Make sure that the topmost company on that list does not have more than 7% to 8%. It is also important to have diversification sector wise. After looking at the portfolio look at past performance of that mutual fund (again for example on moneycontrol.com).
   
   A mutual fund which has satisfactory past performance and a well diversified portfolio is a good low risk investment option.
   
   Choosing a systematic investment plan or an SIP is a good idea in order to minimise risk. In order to further minimise risk you may choose to split your investment or SIP into two to three different mutual funds meeting the criterion.
   
   
6. For those with high risk appetite : For this you have to have a judgement about which sector is going to do well in the near future. For example if you think that construction and real estate are going to go up in the near future, then you can choose a high risk option by selecting a mutual fund which has a large percentage of its investment in real estate and construction companies. You will have to do some searching and researching for this though. Also bear in mind, if your guess is wrong a significant portion of your investment can be wiped out. Merely choosing a mutual fund based on past performance and whose portfolio is not so well diversified (for example one of the taurus mutual funds had around 33% of its investment in JaiPrakash Associates Ltd. - this is way above our 7-8% criterion for diversification) would also qualify as a high risk, although I am not sure that is a good idea.

Related posts :

• Introduction to Mutual Funds
• My own experience with Systematic Investment Plan (SIP)
• Liquid Funds : What, Why, How, etc.