Mutual funds are the rage in India these days! But what makes them so effective and credible and most importantly, useful?
There are easily more than 5 reasons why one would want to invest in mutual funds. However, basis our interactions with our numerous clients we have come across a few top reasons why anyone would want to invest in mutual funds. It should not come as a surprise if you start you mutual fund investments for one of the following reasons.
Did you know mutual fund investments can help you save a good amount of tax every year? How much exactly? Up to Rs. 46,350!
Under Income Tax Act Section 80C, you can exempt up to Rs. 1,50,000 every year from your annual income by investing in certain instruments – one of which is a mutual fund category called ELSS (Equity Linked Saving Scheme)
The most popular of these instruments are –
- 5 year Fixed Deposits
- PPF, EPF
Among these and others that haven’t been mentioned, it has been observed that ELSS yields highest returns consistently with the lowest lock-in (3 years). So, not only do you end up savings taxes but also your money grows at a faster pace than it would have in FD’s or PPF.
Also, ELSS can serve as a good starting point for new (read jittery) mutual fund investors since your money gets locked-in for 3 years. If you redeem it, you have to pay taxes that you managed to save!
Have you ever observed that the money in your bank account some time tends to deplete at a rate faster than it is replenished by your monthly salary? No, nothing is wrong with you. You’re human like everyone else.
One of the biggest reasons it is recommended you invest in mutual funds is so that you inculcate financial discipline. To form a spending-saving pattern.
If money is at your easy disposal, you will always tend to splurge it on unnecessary things. A mutual funds investment mechanism called SIP – Systematic Investment Plan – will make sure that you spend wisely. How?
Let’s say Ajay has a take-home monthly income of Rs. 1,00,000. He needs only Rs. 60,000 for his regular expenses – food, rent, commute etc. What should he ideally do with the rest of his monthly income? If he keeps it in the bank, it’s at his easy disposal and he will want to spend it!
The answer is simple – set up an automatic mechanism for deduction of this Rs. 30,000 (Rs. 10,000 goes towards arbitrary expense) every month around his salary date. Depending up on when Ajay may need the invested money back, he can invest in different types of mutual funds under the guidance of an advisor.
Another aspect is that not only will Ajay be able to save his money and grow his money faster than the bank savings rate of 4-6% PA, but also have lesser tax liability when compared with simply storing the excess money in savings bank account.
Inflation is something most people forget to consider when it comes to money. The simple concept is that money loses its value over time because the things money can buy become expensive over time.
RBI’s target is to keep the inflation rate at 4% with a tolerance of 2% – meaning, as far as possible, RBI will try to maintain an inflation rate of 2-6%.
Assuming an inflation of 5%, if item A costs Rs. 100 today, a year from today it will cost Rs. 105 if the rate of inflation is 5% PA. The next year it will cost Rs. 110.25…
What about the money in your bank account? It will grow at just 6% (in the best case) and let’s not forget the taxes! Any interest earned from savings bank account, fixed deposits beyond Rs. 10,000 per year is charged at marginal tax rate. This means that the effective interest rate for someone who falls in the highest tax bracket is about 4.14%!
In the above scenario, every year you park money in your savings bank account, it loses roughly a percent in value. Think about it – You saved Rs. 100, and before you know it, in a year’s time you are able to buy just Rs. 99 worth of stuff! You keep it in the savings bank account for another year, the value further depreciates to Rs. 98! You’d worked for Rs. 100 a couple of years ago, but today it has become Rs. 98 in value.
Here’s how it exactly works!
You need to invest your money into instruments which have post-tax expected returns of at least the prevalent rate of inflation (marked red) else your simply loses value!
Debt funds have an expected rate of return of the prevalent FD rates (some even higher) and 12% is a safe rate of return to assume IF you are going to invest in equity mutual funds for a period longer than 5 years. This is necessary because any equity mutual fund’s performance is highly correlated to that of stock markets which attracts volatility every now and then.
Superior Alternatives to Fixed Deposits
Fixed Deposits’ Disadvantages –
- Interest fully taxable*
- Penalty if prematurely withdrawn
- Interest rate risk
All these disadvantages do not apply to the relatively safer debt mutual funds!
If you are risk averse, you’ll be better off investing in debt mutual funds instead of fixed deposits in more aspects than one…
Depending up on your needs, you can invest in various types of mutual funds Investment.
For example, if you are looking to create an emergency corpus, it is recommended you invest in liquid funds. As the name suggests, the money invested in liquid funds is highly liquid (back in to your bank account within 24 working hours!) but the rate of return on liquid funds is double that most of savings bank account rate (3.5% versus 7%)
Buy a car!
Or a house, or plan your retirement. Mutual funds Investment are great to plan financial goals!
It is highly recommended that you start with a financial goal in mind, a few typical goals people try to achieve via mutual fund investments are –
- Buying a House
- Children’s Education
- Post Retirement Planning
Learn how to define a financial goal here!
Here’s an example of how an equity mutual funds SIP can help you buy a house 10 years down…
A house that costs Rs. 50,00,000 today shall cost around Rs. 81,50,000 after 10 years assuming a 5% inflation rate.
If you put aside Rs. 40,000 every month in savings bank account to buy this house after 10 years, you would fall short by around by Rs. 23 Lakhs. However, if you invest the same amount in a set of equity mutual funds Investment, you should be able to buy that house!
In both the cases, you set aside about Rs. 48 Lakhs over 10 years. But the difference in corpus that potentially gets created via the two instruments is simply huge!
There are some savings bank accounts which do give a 6% annualized return but again most mutual funds Investment have performed far better than the conservative assumption made here.
So these are our 5 compelling reasons to start investing in mutual funds – take your pick and start investing!