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Willing to invest in mutual funds? Here are things you must know

  | Published: 15 February 2020 | Last Updated On: 19 January 2021

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Mutual funds are one of the most popular methods for new investors to build wealth. They can significantly help the investors to diversify their portfolio and secure their future. Though everyone today knows that mutual funds exist, there are several things that they are not aware of. As always said, there are two sides to a coin, investing in mutual funds may or may not turn out to be fruitful if important aspects are neglected.

If you wish to invest in mutual funds, mentioned below are things that you must surely know about:-

What are mutual funds?

The first step before you decide to invest in mutual funds is to know what they are and how they actually work. In simple terms, a mutual fund can be referred to as a trust that pools the savings of a number of investors sharing a common financial goal. This pooled money is then invested by professional money managers into various money market instruments such as stocks, bonds, debentures, etc. The income earned via these investments is shared among the investors in the proportion of the units they own. 

To have a clear understanding of mutual funds, look at the image below:-

How to buy shares of a mutual fund?

Now, if you are ready to invest in mutual funds, you must know how to purchase them. The first way to purchasing a mutual fund is to buy it directly from the mutual fund's company. Another way is to invest in mutual funds using Systematic Investment plans or SIPs. Usually, customers are advised to opt for SIPs because investing in long-term equity SIPs will generate better returns.

What is meant by mutual funds sales load?

While purchasing your first mutual fund, you may come across something known as a sales load. Now if you do not understand it, you may end up buying a wrong type of mutual fund digging a huge whole in your pocket. Therefore, it is very important for you to understand sales before you invest in mutual funds. A mutual fund sales load is a type of commission charged to an investor while purchasing or redeeming shares in a mutual fund. These sales charge commissions are determined by the mutual fund companies and charged by the mutual fund intermediaries. The two types of sales charges are:

  • Front-end loads - This type of sales charge is incurred during the time of purchase and may carry a low net expense ratio.
  • Back-end loads - This type of sales charge is incurred when investors sell their fund shares, but their price may decline over time and may even become zero after a certain period of time.

Should you believe in the fund's past performance?

Though the past performance of a mutual fund matters a lot, it is not the only thing on which your investment plan should be based upon. Let us understand it with the help of an example. If a stock goes up by 15 % in a year, it doesn't tell you much about if it is going to be a good investment or not. However, if a stock has on average shown annual returns of 9% for more than 40 years, it may be one of the best mutual funds to invest in. Also, it may happen the portfolio manager that was managing your money earlier has changed and you may not even realize it.

How to know about the hidden tax cost?

Before you invest in mutual funds, it is important that you understand each and every aspect related to it.  For first time investors, it may be almost impossible to figure out the hidden mutual fund tax and they may end up paying a hefty amount from their pocket. The two most common types of hidden costs that the investors may have to pay are tax inefficiencies and transaction fees. Tax inefficiencies mean that the investors are subjected to pay capital gains tax irrespective of the losses incurred. The transaction fee, on the other hand, refers to the nominal amount that has to be paid by the investor once during an investment. A transaction fee can be very low and high depending upon the type of investment and broker.

Should you invest in bond funds or bonds?

Mutual funds are not only for investing in stocks. A common question faced by most of the beginners is if they should invest in bond funds or not. Bond funds pay higher interest rates than other market funds and are a good opportunity for small investors because they are available at smaller share prices.

Can ETFs be a better choice?

An ETF or an exchange-traded fund is a type of investment fund that contains a collection of securities such as stocks, bonds, and commodities. ETFs are in several ways similar to mutual funds, but unlike mutual funds, ETFs share trade throughout the day just like the ordinary stock. Some people may consider ETFs to be better and tax-efficient. However, the choice depends on the investor. For instance, some investors invest in ETFs for sector funds and mutual funds for actively-managed choices. Whatever the investor decides, care should be taken that the investment meets investor's risk tolerance and financial goals.

Now that you know the basics, I would suggest you keep all the aspects in mind before you invest in mutual funds.

Happy Investing!