Why invest in Mutual funds

When we decide to do something in our life, there could be many reasons that guided our decision. But more often than not, there is a single overriding reason that stood above the others and made us act.

When it comes to choosing to invest in mutual funds, it is very similar.

If you ask an advisor or a colleague as to why you should be investing in mutual funds, they will reel off a list of reasons. However, only one will keep you going and make you act.

In this chapter, let’s look at that one reason that will get you going, and of course, spice it up with many other reasons that will just tag along with you.

Why invest in Mutual funds

Returns – The #1 reason

Let’s be clear – we invest to convert our money into more money. We seek profits or returns or appreciation of capital or whatever you choose to call it.

There are many ways to convert our money into more money. If it’s legal in your state, you can buy a lottery ticket and convert your investment into a stupendous amount of money in a short amount of time. You can “invest” in the race track and accumulate a lot of wealth pretty quickly.

Right?

Not really. We don’t do those things – at least not with any significant amount of money. Why? Because the odds of making those outsized profits are infinitesimally small.

In other words, those avenues of “investment” are RISKY.

On the other end of the spectrum, we have our friend, the bank fixed deposit. Although I hesitate to say, in this day and age, that they don’t carry any risk, they are as low-risk as a financial investment can get. So, can we just invest all our money into FDs and go to sleep?

Some of you are probably doing just that presently.

But the problem with that approach is that you make a very meager profit out of your investment.

And what is wrong with making a meager profit? After all, profit is more money than you started off with, right?

The problem is the i-word – Inflation.

Inflation is the incredibly shrinking act that your money does right before your eyes. The value of a rupee reduces every day that you hold it as cash. And if your investments do not grow to keep up with the rate at which the money’s value is shrinking, your overall net worth keeps diminishing.

And a bank deposit is very unlikely to do that, especially after you pay your taxes on the interest earned. 

Let’s take an example – suppose you deposited Rs 1 lakh in a 3-year bank FD in the year 2017. The bank interest rate at that time was 6.25% (large private bank) annually. After three years, you would be receiving Rs 119,946 from the bank. You would need to pay tax on the profit of Rs 19,946. There are many tax slabs – let’s assume you are in the middle income group, paying 20% tax. The after-tax interest/profit/return would be Rs 15,956, and your net money in hand would be Rs 115,956.

While your money was in the bank, what was happening to the rupee in the world? The average inflation rate in that 3-year period was 6%. And that means, the equivalent of Rs 1,00,000 after 3 years was Rs 1,19,102.

So, your money in hand – Rs 1,15,956 is not even worth the amount you invested Rs 1,00,000 as of today.

This is what inflation does to your investments. Effectively, the bank gave you back less money than you invested. So much for the ‘safe’ investment option, eh?

This was, of course, one example from a single period. But this is a story that repeats over and over with such ‘safe’ products. They are not engineered to provide returns higher than inflation.

The only way to make inflation-beating returns is to take some risk. There are no other alternatives.

So, back to the good old racing track or lottery tickets or start punting in the stock market?

Not really.

The solution to the no-risk problem is not hyper-risk.

There is a middle path, and that middle path is mutual funds.

Mutual funds allow you to take measured risks – something that you can calibrate in keeping with your own risk tolerance, your time frame of investments and various other factors. We will take a closer look at these as we go forward.

But for now, let me just tell you that the primary reason to invest in mutual funds is to gain higher returns for your invested money. 

How can mutual funds give higher returns than a bank? Why can’t banks give inflation-beating returns?

The answer to that question is simple – banks have strict controls on what they can do with their money and what they cannot. Lend to a business? Fine. Invest in the stock market? Not fine.

So, banks are structurally incapable of giving high returns on their deposit products.

If you think about it, you will see that it is pretty much common sense. Let me explain with an example.

Suppose you invest in a bank deposit that promises a return of 6% for a year. What does the bank do with this money? They lend it to business at a higher rate – say 8% – so that they can cover their costs and make a little profit for themselves. Also not all businesses repay the money, so they have to cover their risk as well.

Now what does the business do with the money? Invest in their business, of course! But if they borrow at 8% would they want to make more than 8% profit on that money or less? Obviously, more. Let’s say they make 12% by deploying the money they borrowed.

So, you can imagine now – the money that you had in your pocket and put in an FD is capable of generating 12% return. But what do you get? 6%!

Why? Because you wanted ‘guaranteed returns’ with no risk. The bank took a risk with your money, and they made a profit. The business took a risk with your money and they made a bigger profit. And you got a low, guaranteed return.

Now, suppose there is a way for you to make that Rs 1 lakh participate in the business directly, would your return be closer to 12% or 6%? Exactly.

And, if the inflation rate was even at 8%, you will be making inflation beating profits with your money!

That is the opportunity you have when you take some risk with your money. That is the opportunity that mutual funds give you.

The advantage of mutual funds is that it lets you make good returns, while allowing you to take as much or as little risk as you would like to.

In the last ten years (2010-2020), the average inflation rate has been 7.36% every year. In this same period, a bank FD would have earned you between 7% to 8% (based on deposit rates from 2010 onwards, assuming redepositing after maturity.) before taxes.

Here are some mutual fund returns for the same period – for now, let’s focus on the inflation-beating, business-owning mutual funds called equity mutual funds. 

All rates compounded annual rate – as were the inflation and deposit rates:

Mutual fund categoryAverage return 
Equity funds – Flexi cap funds12.69%
Equity funds – large cap funds11.33%
Equity funds – large and mid-cap funds13.69%
Equity funds – tax saving funds13.07%
Equity funds – Small cap funds15.97%

You can see that, even after taxes, the profits from mutual fund investing will blow away the inflation rate.

Which means, you will have more money in your account, even after taking into account the erosion caused by inflation.

Isn’t that why we should be investing? To make sure our money retains its value and, hopefully, grows a bit?

Yes, it is, and that’s the biggest reason to invest in mutual funds. 

Now, let’s look at the other reasons why mutual fund investing makes sense.

Mutual funds are versatile

What is versatility? We call a movie actor versatile when he or she can don different types of roles – hero, anti-hero, comedian, villain etc – and do them well. For example, down in south  India, we call Kamalhassan a versatile actor due to the range of roles he has portrayed.

Similarly, an investment instrument can be called versatile if it can be used for a variety of investment purposes. To give you a contrast, let us look at an example of an investment instrument that is not so versatile.

A lot of people think of real estate as an investment. And yes, it can be used as an investment asset. However, is it a versatile asset?

  1. Can you invest in real estate for an investment time frame of 2 weeks? How about for 2 years?
  2. Can you invest Rs 10,000 in a real estate property?
  3. Can you invest a small monthly sum in real estate?

Clearly, the answer to these questions are no, no, and no. Real estate is at best a long-term investment that is hard to get into (requires a large sum of money) and hard to get out of (need to hunt for a buyer). It cannot be used for short-term purposes, and you cannot invest periodic amounts of money in it.

We can make similar analysis with other investment options like fixed deposits or gold. 

On the other hand, when it comes to mutual funds, you can invest in it for a variety of time frames – ranging from 1 week to 20 years and beyond, you can invest in it with a variety of amounts – from as low as Rs 500 to as high as you can go, and you can invest whenever you want.

There are a variety of mutual funds – different types and categories – that will be suited for different types of investor needs. Of course, the key – and this is the important thing – is to know which type of mutual fund suits which type of investment needs. But once you figure it out, you can use the power of mutual funds and invest in it for any purpose, any time frame, and any financial situation.

That is not all – mutual funds are versatile in another important way too. They can act as conduits – pathways – for an investor to invest in a variety of instruments.

If you want to invest in the Indian stock market, of course, there are many many funds to do so. But, mutual funds are not about stock market investing alone.

If you want to invest in the bond market (the deposit or fixed income market), you can do so with mutual funds.

If you want to invest in gold, there are mutual funds for that.

If you want to invest in commercial real estate, MFs have you covered.

If you want to invest overseas – say the US market – there are many funds for that.

In short, mutual funds allow you to invest practically anywhere, in anything for any purpose and any time frame. It is quite amazing if you think about it!

This versatility is what many, many people find very attractive about mutual funds – since they can practically take care of all their investment needs through this one vehicle.

Mutual funds are liquid

More and more, the concept of liquidity is becoming an important consideration for investors, and mutual funds trump here also. 

What is liquidity? Simply put, it is the ability to get your money out of your investment when you need it with minimal issues.

Once again, let’s take an example of something illiquid – obviously real estate would come under this category – you can just sell your property in a few days and cash out quickly. You will need to get a broker, find a buyer, and go through an elaborate process before the money hits your account.

With deposits and gold, it is a bit easier, no doubt. However, with deposits you are likely to get hit with penalties for preterm closure, and with gold, you need to worry about not getting conned at the till.

With mutual funds, when you need the money, you go to the online platform that you are investing through, hit a ‘redemption’ button and specify how much money you want to take out. In most cases, the money will come to your account in a maximum of 3 business days. 

There are some exceptions to this – in the case of a tax-saving mutual fund (where you invest to reduce your tax outgo), you will be unable to redeem within 3 years of investment (similar to tax-saving fixed deposit, where the lock-in period is 5 years). And if you invest in overseas funds, the redemption payout may take 10-12 days to come to your account.

But in most cases, you can see your money, its current value, and if you choose to redeem, you can hit a button and claim it.

This ease of access to your money is one of the most attractive features of mutual fund investing, and with the advent of online platforms, it has gotten only easier.

Mutual funds are tax efficient

As the saying goes, there are only two inevitable things in life – death and taxes. No one making any income, revenue, or profit can escape paying taxes.

However, if there are perfectly acceptable and legal ways to reduce your tax outgo, why would we not want that? Mutual funds allow you to do that.

Before we get into details on that, let’s look at the bigger picture for a second. The government taxes individuals under many headings – income (salary), interest (what we get from our deposits), rent, and capital gains are the most prominent ones among them.

Among these, our income gets taxed at a rate that depends on our overall annual income that we make. And as we make more and more income, as we grow in our life and career, we end up paying a higher and higher percentage of it to the taxman.

On the other hand, capital gains are taxed at a constant rate – regardless of how much capital gains you make, you pay the same rate (minor exceptions – we will get to that in a bit). And, usually, this tends to be lower than the income tax rate except for those in the lowest income bracket.

We will cover this topic in more detail in the final chapter of the book that is exclusively on taxation. For now, let me just say that you can invest in mutual funds in a way that will really minimize your tax outgo since they will be treated as capital gains.

This is especially true with mutual funds that invest in the Indian stock market. However, this is also true, although to a lesser extent, about funds belonging to other categories.

Most importantly, this is true when you compare mutual funds and fixed deposits.

Let us take an example – suppose you invest in a deposit that pays out 10% annually. If you invest Rs 100,000 for a period of 3 years, your money will grow to Rs 1,33,100 – a profit of Rs 33,100. All this money will be taxed as income in your hands – which means you will pay whatever your top income tax rate is on this profit. If you belong to the 30% bracket, for example, you will pay Rs 9,930 (roughly, ignoring cess and other levies) as taxes.

It works differently with mutual funds. If a debt mutual fund (a variety of mutual funds that is comparable to a fixed deposit) returns the same 10% annually for 3 years, you will have the same profit, but these will be treated as long-term capital gains (3 years of investment period is required for such a treatment). And this money will be taxed beneficially after taking into account the inflation during this period.

If we assume that inflation was 6% on average during this time period, you will only pay taxes on the returns you made post-inflation. Without going into the arithmetic of this (which we will later on in the book), I can tell you that your tax outgo will be, roughly, Rs 2,800.

Rs 9,930 vs Rs 2,800!

A significant difference right? The story gets better still when you consider domestic equity fund investments, but we will get to that later.

Key point to note is if we invest in mutual funds the right way, we not only will likely get a better return on our investment, we will also have a smaller tax payment to make.

That’s what I call a win-win!

Mutual funds help you manage risk

Risk is the conjoined twin of returns when it comes to investments. Even if you just keep money in your pocket, there is a risk associated with that – remember, inflation keeps eroding its value! Money in the savings account has a small, but measurable, risk associated with it (bank could go down). So, even idle money has a certain amount of risk that comes with it.

When you take the money out of your pocket or your savings account and deploy it as an investment, there is still further risk associated with it in varying degrees.

If we ignore the effect of inflation, and define risk as the amount of danger that your principal amount – the sum that you are investing – is in, we can calibrate it along a scale of 1-100. The money in your pocket carries a risk level of 0 and the money in your bank account a risk level of 1. The money in a fixed deposit has a slightly higher risk, say a level of 5, and so on.

Does an investment in real estate have risk? Of course it does! And is it more than the risk in fixed deposit? Yes. Real estate prices don’t always go up and there could be long periods of stagnation as well, especially after taking costs into account.

Do gold investments have risk? Certainly – gold prices move up and down on a daily basis, and there is no telling where the price will be when you want to sell.

Investments in mutual funds also carry a risk.

The good news, though, is that risk is mutual funds can be calibrated and managed. This is the key, and the main difference between managing risks with mutual funds and other investment options. 

For example, there is no way you can buy a certain type of gold that is riskier than another type of gold. Or do something like that with real estate, for that matter. Not in any measurable manner, anyways.

Mutual funds are organized by various categories – each of which has a distinct risk level associated with it. On our scale of 0-100, mutual fund categories would probably range from 10 to, say, 60 or 70. There are riskier still investments out there beyond mutual funds (bitcoin, anyone?).

So, when you invest in mutual funds, you can pick and choose different funds in different categories that match your risk profile or risk requirement. For example, if you need to make an investment for the next 3 months, you would choose a mutual fund that is very low in the risk scale – since you would need the money back quickly. If you are investing for the next 20 years, you can afford to take more risk with your investments. And you can mix and match funds in a million different ways to create the right risk level suitable for you and your investment time frame.

I do not know of any investment instrument that is so amenable to managing risks in this manner. And for people whose job it is to advise other people about their finances, such an instrument can be god-send – they can tailor a ‘portfolio’ for their customer to the tee.

But…(there is always a ‘but’)

So, you have 5 reasons listed above – any combination of which will make it a good decision to invest in mutual funds.

However, I would be remiss in my duties as an impartial explainer if I don’t round off this chapter with a few things that you should also be aware of when it comes to mutual fund investments.

  1. No guaranteed returns
  2. Difficulty choosing 
  3. Expenses
  4. Bad actors

First and foremost, it bears mention and emphasis that mutual funds do not provide any guaranteed returns. There is no type of mutual fund, no category – not even the lowest risk category – that provides such an assurance. Some people may say that there are ways to find out how much a fund would return by looking at the portfolio and what is in there, but those would just be guesses. The mutual fund company itself provides no guarantees.

Such a lack of guarantee is what spooks many investors when they first learn about mutual funds. As an investing class, people who are starting out, always ask the question as to ‘how much will it give’ when introduced to mutual funds. When the answer that they receive is laden with uncertainty, it immediately becomes a red flag for them.

That is unfortunate, really. Mutual funds have had a track record of more than 25 years (as of this writing in 2021) delivering returns in keeping with the risk and investment profile of their portfolios. People who shy away from funds for this reason are missing out on significant wealth-building opportunities because of that. They also lose sight of the fact that there are NO investment instruments that offer a guaranteed return that can keep up with inflation in the market.

A reasonably well-maintained portfolio of funds, when held over the duration of time that it was designed for, has a very high probability of meeting any reasonable returns expectation of the investors. When it comes to investing in inflation-beating instruments, only time is the antidote to risk.

The second concern about difficulty of choosing good funds is a real one. There are close to 1500 mutual fund schemes in the market across various categories, with more coming up each day. Not all of them are good or as well-managed as they could be.

Then, how does an investor go about choosing the right fund for themselves and their needs? It is not a trivial problem. But it is a solvable problem. Today, there are several ways to solve this problem:

  1. Hire an advisor – get an expert to guide you. The cost of such a service will be well-worth in the long run.
  2. Use research and recommendation services – there are a few available in the market, including, if I may say so, our services at PrimeInvestor. These services will let you separate wheat from chaff and guide to put together a good portfolio.
  3. Learn, research, and build the acumen – needless to say, the best method, but also the toughest in terms of time, effort, and aptitude required.

The third concern about expenses is a red herring. ALL investments have expenses – some are better hidden than others, that’s all. Even deposits in banks have expenses – just that they are not visible to you. In mutual funds, they are explicit and openly stated. And, in many cases, especially when it comes to direct plans (more on this later), they are among the lowest among investment options. In my opinion, the ‘expense’ excuse for not going for mutual funds is either misrepresented, overstated, or both.

The final one is about bad actors. That is, companies that do not behave or operate in good faith in the market. Such instances are vanishingly rare in the mutual fund industry considering how well they are regulated by the market regulator SEBI. However, there have been recent headline-making instances where this ugliness has reared its head. This is an area that investors need to be aware of and wary about. But, again, it is neither big enough or widespread enough to warrant a shunning of this investment class. At least as of now.

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