What is the first thing you think of when I say the words; amusement park.
Was it a roller coaster?
For many people, that is the image that instantly pops into their mind.
Mutual funds have a similar association with risk. One of the first things one thinks about when one thinks of mutual funds is risk. Of course, mutual funds do involve a certain element of risk, but so do almost all financial products like ULIPs (unit linked insurance plans) and even the NPS (National Pension Scheme) as they also invest in the stock market. But somehow risk is not the first association we make when we think of these products.
Our perceptions influence our investment decisions so today we are going to bust some Mutual Fund myths.
Myth: People feel that Mutual Fund dividends are an additional income over and above the capital appreciation.
When we rent out a house, we get rent as additional income over and above the capital appreciation of the property. Similarly, many of us think of dividends as additional income. Many investors choose the dividend option believing that they will earn higher returns than the growth-option, as these dividends will be declared over and above their regular capital gains. In reality, dividends represent nothing but a portion of the capital gains themselves.
Suppose you invest 10 lakh rupees in a mutual fund and it becomes 12 lakh in a year’s time. The AMC gives Rs 1 lakh as dividend and reduces your investment value from 12 lakh to 11 lakh. And you cannot choose when you receive dividends. You may not receive it when you need it and vice versa. So, it is like withdrawing a part of your accumulated profit. You also lose on the compounding in the long term, as less money is put to work subsequently.
Taxation of Dividends
Dividends obtained from a mutual fund were tax-free for investors until 31 March 2020 (FY 2019-20). That was because the company declaring such dividends already paid dividend distribution tax (DDT) before making payment. However all dividend (on both equity and debt mutual funds) received on or after 1 April 2020 is taxable in the hands of the investor as per the applicable income tax slab. The Mutual fund house will also deduct 10% tax at source before distributing the dividend over ₹5,000.
If you’re looking for a regular monthly income, you can choose the Systematic Withdrawal Plan. Click here to learn all about this option.
Myth: Funds with lower NAV are better than those with higher NAV
Sometimes during our conversations with clients they ask us what is the NAV of this fund, and they would like recommendation of newer funds that are getting launched or with lower NAVs.
Does a lower NAV mean the fund will deliver higher returns?
Most new fund offers (NFOs) have an NAV of Rs 10. It is widely believed that it is better buy during the NFO period or when the NAV is low rather than later when it shoots up to Rs 30 or Rs 40.
It is not true that NFOs are cheaper. Unlike in shares or bonds there is nothing like cheap NAV or expensive NAV in mutual funds. It is important to understand the relationship between the NAV and the amount you want to invest.
For example: Suppose, scheme A has a NAV of 20 rupees per unit and scheme B has a NAV of 100 rupees per unit. You choose to invest 10,000 in each scheme. You will be allotted 500 units in scheme and 100 units in scheme B. Now, assume that both the schemes appreciated by 10%. This means that the NAV of scheme A rises to INR 22 and the NAV of scheme B rises to INR 110. In both cases, you stand to gain 1000 rupees. Therefore, the current NAV of a scheme does not impact on its potential to generate future returns.
Myth: All Mutual Funds are Risky.
It is a common belief that mutual funds only invest in the stock market. This is not the case. There are funds that invest entirely in debt. Not just that but Debt Mutual Funds have a significantly larger corpus than Equity Mutual Funds.
- Mutual funds are divided into categories like equity, debt and other money market instruments.
- There are funds like the balanced fund, which invest in both equity and debt, in order to minimize risk.
Mutual funds carry a perception that they invest only in equity and hence are risky. There are different kinds of Mutual Funds to cater to various investment requirements. Some investors want high returns which only stocks can deliver. Such investors can invest in Equity Mutual Funds which are among the best long-term investment opportunities available for achieving such objectives. But these Mutual Funds have risk of higher volatility because of their exposure to the stock market.
There are other kinds of Mutual Funds that do not invest in equity but in bonds issued by banks, companies, government bodies and money market instruments (Bank Certificates of Deposit, Treasury Bills, Commercial Papers) which offer lower risk but also have lower returns compared to equity funds. These funds are better suited as substitutes to traditional options like bank fixed deposits or PPFs. So if you are looking to invest your money to give you better returns than a bank or post office FDs while being tax efficient, Debt Mutual Funds are a good option to achieve such financial goals.
Myth: Mutual Funds are only for Long Term Investments
It is advised that one invests in mutual funds for the long term, but you can invest for a short term as well.
- There are different investment timelines while investing in mutual funds, like long-term, short-term and medium-term.
- Categories like short-term debt funds and liquid funds are best suited for investing for a short or medium duration.
Myth: One needs a sizeable corpus before one can start investing.
- You do not need to have a bank balance of lakhs to invest.
- It is completely false that you must invest a lumpsum amount if you want to pursue investing regularly. It is possible to invest periodically through mutual funds, by investing through the Systematic Investment Plan (SIP’s)
- You can simply invest small portions every month or so.
- Through compounding, a small sum of money can convert itself into a large amount
Let’s say you’re starting your career and your salary is Rs.20,000. You might think investing 2,000 or 5,000 out of this is rather insignificant. That is a false notion. When that same money is invested and re-invested, it is seen that the returns you accumulate are excellent if you have remained invested for a long duration (more than 7 years).