Mutual funds have become a popular starting point for people looking to invest for long-term goals, but choosing the right scheme can be difficult for a first-time investor. There are hundreds of mutual fund schemes across large-cap, flexi-cap, mid-cap, small-cap, hybrid and debt categories, each with different levels of risk, return potential and investment horizons. The sheer number of choices can also push new investors towards a common shortcut, picking a fund simply because it has delivered the highest recent return.
But past performance alone does not tell an investor whether a fund is suitable for their financial goal or whether they will be able to stay invested when markets fall. For a first-time investor, the starting point should be the goal, the time available to achieve it and the level of volatility they can realistically tolerate.
Rhishabh Garg, CEO of FundsIndia.com, explains how investors can narrow down their choices and select a mutual fund without getting overwhelmed by the options.
Start with your goal, horizon and risk appetite
For a first-time investor, three factors should come before looking at individual mutual funds. The first is the financial goal and the time available to achieve it. Money required for a holiday in two years, for instance, should not be invested in the same type of fund as money being set aside for retirement over 20 years.
The second is the investor’s ability to tolerate a fall in the portfolio. Garg said investors should assess not what they claim they can tolerate, but how they would actually react if their portfolio declined 20-25% during a difficult market phase.
A fund that an investor is likely to exit during the first major correction may not be the right fund for them, even if its historical returns look attractive.
The third consideration is the fund itself, including its category, performance across different market cycles and cost. These factors should be considered only after the investor has established their goal and risk tolerance.
How to choose the right mutual fund category
Garg recommends working backwards from the financial goal. Debt funds can suit money required in a year or two, while hybrid funds may be appropriate for goals that are a few years away. Equity funds are better suited to goals with a horizon of five years or more.
Within equity, large-cap and flexi-cap funds can form a core allocation for many first-time investors. Mid-cap and small-cap funds can offer higher growth potential but also tend to experience sharper swings. Garg therefore sees them as better suited to a smaller allocation rather than as the starting point for a new investor.
The appropriate mix also changes depending on the goal.
For a three-year goal such as a down payment, the priority should be protecting the money. Garg said such an investor could focus largely on debt or short-duration funds, with a small hybrid allocation if appropriate.
For a five-year goal such as school admission, a combination of growth and stability may make more sense. An investor could consider a hybrid or flexi-cap fund alongside a meaningful debt allocation and gradually shift towards debt as the goal gets closer.
For a 10-year goal such as retirement, the portfolio can have a much higher equity allocation because the longer investment horizon gives the investor more time to ride out market declines.
Since investors often have multiple financial goals at the same time, each goal may require a different asset allocation. Garg said an investment expert can help map each goal to an appropriate mix and revisit the allocation as the goal approaches.
Don’t choose a fund only because of recent returns
Past returns are useful, but they should not be the deciding factor, Garg said.
A fund at the top of the one-year return table may simply have benefited from a particular investment style or market segment being in favour during that period. Such leadership can change as market conditions rotate.
Instead of focusing only on one-year returns, investors should examine three-, five- and, where available, 10-year performance. They should also look at how the fund performed during falling markets and compare its performance with its benchmark and peer funds.
For a first-time investor, consistency can be more important than finding the fund that delivered one exceptional year. “Steady returns are easier to hold than one spectacular year between weak ones,” Garg said.
A simple framework to shortlist a mutual fund
For investors who feel overwhelmed by the number of schemes, Garg suggests a simple “Goal, Category, Check” framework.
The first step is to establish how much money is required and when it will be needed. The second is to select the category that matches the investment horizon and risk tolerance. This can narrow hundreds of schemes down to a manageable shortlist.
The final step is to compare three or four funds on long-term consistency against peers, costs and the stability of the fund house. From there, an investor can select one or two suitable funds rather than spreading money across too many schemes.
For a first-time investor, starting with a single diversified fund and building from there can be more effective than buying five funds at once. The aim is not to own as many schemes as possible, but to choose investments that have a clear purpose and that the investor can continue holding when markets become uncomfortable.