What are mutual funds?

Many times we come across people who want to know what are mutual funds. I have tried to explain below a detailed answer on the same. Hope you will understand it

Let us simplify this for everyone to understand.

Consider this conversation between father and son. The curious teenager seeks advice from his Dad on Mutual funds. In the process, he realizes the importance of the same.

Son: Dad, what is a Mutual fund?

Dad: Do you know how to drive?

Son: No.

Dad: But, if you have a car and you don’t know how to drive, how will you reach your destination?

Son: Its simple Dad. I’ll hire a driver for me.

Dad: That’s exactly why we need mutual funds. You see son, investing in the stock market is a risky business. It is an art. If you know how to drive, then you do not need a driver. But, if you don’t know how to drive, you will need one. Mutual funds are managed by experts and people who do not want to take the risk of investing their money all by themselves, rely on the Mutual funds which are managed by the experts. It is akin to relying on a driver in case you do not know how to drive.

Son: Where is the money invested by the mutual funds?

Dad: There are different kinds of Mutual funds. Some invest only in equities, some invest in equities and debentures. Then there are other mutual funds who also put some money in gold and bonds.

Son: But how to know which category is best suited?

Dad: Okay, can you answer this simple question: ‘For how many minutes do you boil the milk?’

Son: Umm, 5–10 minutes may be! Or 15 minutes!

Dad: There is no one answer to this question. The answer depends on the fact as to for what purpose you are boiling the milk? If you want to drink the milk, then you boil it for 5 minutes. But, if you are making some dessert, then you would probably boil it for 15 minutes. You see, the same theory applies in case of selecting the category of a Mutual fund. If your investment goal is short term, say buying a car, then a hybrid of debt and equity would be more suitable as it is less risky and you need back the money in a less span of time. But, if your goal is something like marriage of your kids then equity oriented mutual funds are better suited. This is because over a longer period of time, equity can give handsome returns.

Son: But Dad, I don’t have much money to put in the Mutual funds. What should I do?

Dad: That’s the best part of investing in a Mutual fund. You can start even with Rs.500 a month. You can increase the amount to be invested as and when you have more money. Mutual Funds have a huge inflow of money from people like us and hence even with the investment of Rs.500 a month, you will be able to buy shares of companies whose share price is more than Rs.500.

Son: Don’t you feel it is a bit early for a teenager like me to put the money so early?

Dad: No son. It is never too early to invest in Mutual funds. We can not time the market. Hence, it is always better to start early. Plus, the power of compounding will help your fund to grow exponentially. All you need to have is discipline. Do not time the market but give your time to the market. In a cricket match a huge score can be chased even by singles and doubles if we are disciplined.

Son: What should I do in case of a stock market crash.

Dad: You can invest the money in the Mutual funds in two ways: Lump-sum amount or through SIP (Systematic Investment Plan). It is recommended to put the money through SIP. In case of an unstable market environment, you can avoid the risk of putting a lot of money at once if you follow the SIP route of investment. In case of a stock market crash, it is always recommended to continue your SIP. In longer term you will realize that you have gained a lot owing to buying the stocks at a cheaper price during the crash.

Son: Thanks! That was a lot to learn. I’ll be starting the investment as early as possible.