Prospective investors need to hear this cold fact. If you are serious about investing, you need to be prepared to take risks. There are no rewards in the world of investing if the investor does not take any risks. However, that does not mean that you should invest blindly. Risks in this sense refer to calculated risks. That means, before your funds are allocated to an asset, please make sure to conduct thorough research of its past performance. If it meets the parameters of a well-performing asset, then, please go ahead and take that calculated risk. But before opting for an investment tool, please make sure to learn everything about it.
One of the most prominent examples of an investment tool is mutual funds. They are an investment product that pools money from a group of investors to purchase different securities like stocks, bonds, gold and money market instruments. But one of the important things to look for while investing in mutual funds is that you need to check what type of mutual funds you are opting for as an investment option. Some of the popular examples of mutual funds are equity funds and debt funds.
What is an equity fund?
These are the funds that are known for allocating a major part of their asset in equity shares of various companies in different proportions. Asset allocation here is dependent on factors like the type of the equity fund and its alignment with the investment objective. After carefully analysing the market condition, the fund manager allocates the assets in stocks of small-cap, mid-cap, or large-cap companies. After that, the remaining amount is invested in things like money market instruments and debt. Taking this action helps with things like bringing down the element of risk and taking care of sudden redemption requests. Before opting for equity mutual funds, you should make sure that your decision to invest must sync with things like your risk profile, investment horizon and financial objectives. If you have a long-term goal on your mind, you should seriously consider investing in equity funds. Doing this will provide your funds with the much-needed time to combat market movements and fluctuations.
What is a debt fund?
Debt funds are known for primarily allocating funds in debt and money market instruments. Some prominent examples include things like commercial papers (CPs), Treasury bills (T-Bills) and certificates of deposits (CDs). Examples of debt market instruments include non-convertible debentures (NCDs), Government Bonds or G-Secs. The main aim of investing in things like debt or money market instruments is to enjoy income in form of interest payments. Apart from earning income, which is the primary investment objective in debt funds, some interest rate calls can also generate capital appreciation for investors. What differentiates a debt fund from an equity fund is that debt funds have considerably lesser risks compared to equity funds. Apart from that, another major difference between the two is that there are many types of debt funds which help you invest even for one day to many years. For instance, overnight funds invest in instruments which mature overnight. Liquid funds allocate funds in securities which mature in less than 91 days.
Why include debt funds in your equity mutual fund portfolio?
Before learning the reason why you need to include debt funds in an equity-heavy portfolio, let’s look at some of the risks associated with an all-equity portfolio:
- Market risks – These are the primary risks affecting equity funds. Market risk in simple words is the risk of loss in value of securities due to a wide range of reasons that affect the entire stock market. Therefore, market risk is also referred to as systematic risk i.e., the risk that cannot be diversified away. These risks can be attributed to factors such as macroeconomic trends, global economic crisis, geopolitical tension, or even regulatory changes.
- Industry-specific risks – Equity funds are known for investing in companies across different industries or sectors, and therefore they are exposed to industry-specific risks. That means, the risk of an unfavourable development adversely impacting the companies within an industry. These funds can also be impacted by unfavourable development around a company like a change in management or company policy. This is referred to as company-specific risk. Industry and company-specific risks can be easily mitigated through diversification.
Now that we have looked at the risks, let’s look at what can be done to mitigate the said risks:
- Please ensure that the funds are diversified:
Diversifying is a technique that helps in reducing the risk factor by allocating investments across various financial instruments, industries, and other categories. Diversification aims to maximize returns by investing in different areas that would each react differently to the same movement. Also, diversifying the investment portfolio will help you to reach long-range financial goals. In an equity mutual fund, you are exposed to various stocks. Hence, even if some stocks in the portfolio were to underperform, the overall portfolio may still be able to generate decent yields. Diversifying also come with benefits. One advantage is that it helps the growth of an investment portfolio. Also, it familiarises an investor with different investment strategies.
- Choose to invest in pure debt avenues:
Another option you could take is to opt to invest in debt investment avenues such as overnight funds, ultra-short duration funds, low duration funds, liquid funds and corporate bond funds. Regarded as a relatively stable option, these funds aim to provide regular revenue to the investors.
- You could opt to invest in a sub-category of mutual funds i.e., hybrid funds:
These funds are known for investing in both debt and equity instruments, which helps to achieve diversification and avoid the concentration risk. A perfect blend of the two, hybrid funds is known for offering more stable returns than a regular debt fund while not being as risky as equity funds. The choice of a hybrid fund depends on your risk preferences and investment objective.
Please remember that there is no one-stop guide or rule for successful investing in mutual funds. Simple things like choosing the right investment avenues that sit with your investment horizon and risk appetite, remaining invested for the long term and periodically reviewing your portfolio performance and rebalancing hold the key to wealth generation.
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.