Lot of people believe that investing in a fixed deposit does not carry any risk. If fixed deposit is offering you 8% p.a. rate of return and inflation is 9% p.a., you destroy your wealth by 1%. In a fixed deposit, the capital is not protected against the fall of value in real terms. Therefore, you must have a mix of assets including mutual funds so that your portfolio can grow on an inflation adjusted basis. In order to understand where you can invest, it is worthwhile to talk about your investment options.
Mutual funds invest in different asset classes including equity, debt and gold. Real estate is also an asset class that is available overseas as an investment choice, but these are yet to come to India though the process is on. Higher return seeking investors, who do not mind taking some risk, look at equity as an investment destination. Shorter-term investors, who may want to keep money liquid, need some sort of regular income or keep capital protected; look at mutual funds that invest in debt products. Investors seeking to diversify their portfolios and guard against inflation buy some gold through a fund. And then there are those that want a fund to take care of multiple needs and look at hybrid products. Within each asset class, there are further subdivisions. The three broad categories, or distinctions, are as follows:
Equity funds are those that invest in shares of companies that are listed on the stock exchanges.
Large-cap These funds invest in larger and well-established companies in the market such as SBI, Infy, Reliance, HUL and so on. Large-cap funds are, typically, the least risky funds. These companies are among the least volatile companies as they are mostly in mature businesses. You must allocate highest to this category of investment. Allocate 60% of your equity investment in a large-cap category.
Mid- and small-cap These funds are riskier than large-cap funds. They invest in small-sized companies that are in their growing stages. The larger companies of today were once upon a time small- and mid-sized companies. Since these companies are in their growing stages, they can get volatile in an uncertain market. These are high-risk companies; they typically rise more than large-cap funds in rising markets, but fall more than large-cap companies in falling markets. Allocate 30% of equity investment in this category.
Sector/thematic While sector funds invest in one or two sectors, thematic funds invest in a bunch of sectors that are woven by a common theme, such as infrastructure, consumer spending, fast-moving consumer goods and so on. These are the riskiest of all types of funds as their portfolios are typically very concentrated. Do not allocate more than 10% of your equity investment into this category.
Debt funds invest in fixed-income yielding instruments. There are many types of debt funds, but broadly they fall into three broad types.
Bond funds invest in corporate bonds and partly in government securities. These funds are long-term and short-term in nature. Typically, long-term bond funds carry an average maturity of around three to about five or maybe even 10 years. The longer a debt fund’s average maturity, the riskier it gets because scrips with long maturities take a long time to get wound up and therefore get exposed to market vagaries and volatilities for a long time. Depending upon the interest rate environment you must allocate to these funds. If the interest rates are expected to fall, you may allocate more on funds with longer maturity.
G-Secs The second type of debt funds is government securities (G-sec) funds. Like bond funds, these too come in long-term and short-term variety. These are mostly seasonal funds as they invest only in government securities; scrips issued by the Reserve Bank of India. Though government securities are the safest debt instruments because they are issued by the government of India and hence come guaranteed, they are also the most volatile because they are the most liquid debt instruments in the debt market. Allocate to these funds when you expect interest rates to fall.
Liquid and ultra short-term funds are meant to park your surplus cash instead of lying in a savings deposit. While liquid funds are meant to park your cash for up to a month, use ultra short-term funds if you wish to invest your cash for up to three-six months. These are considered to be the least risky because they invest in scrips that mature in a very short time. Typically, in steady markets, if liquid funds fetch around 8% returns per annum, ultra short-term funds can return about 10% returns. Compared with them, an FD with a bank earns only post-tax 6.5%. In an uncertain interest rate environment you may have a high allocation in liquid/ultra-short term fund.
Gold funds invest in gold bars or gold-backed securities. Gold funds are of two types—those that mimic gold prices in the form of an index fund and those that buy shares of gold mining companies. You must invest not more than 10% of your portfolio in a gold fund and these should primarily be invested in the form of gold exchange traded fund (ETF).
Hybrid funds invest across equity and debt asset classes. They are either balanced funds (invest around 65% in equities and rest in debt) or monthly income plans/regular income plans (invests upto 25% in equities and the rest in debt). You are better off investing into a debt or an equity category instead of a hybrid fund.