Exploring the basics of mutual funds and how to calculate returns
In the current world, every individual is searching for options where his wealth can be increased, and one of the best ways of doing this has been through investment. First-time investors are making mutual funds a popular form of investment today. They are quite simple ways of investing in stocks and other kinds of assets without too much expertise. It makes it easy for new investors and even those who have been thinking about the investments to consider them for a long period. This article will help you understand the very basics and guide you through the returns that can be received from your investment.
What is a mutual fund?
To answer the question, what is a mutual fund? A mutual fund is a kind of investment in which a large number of people pool their money to buy stocks, bonds, and other securities. Professional fund managers run the fund by investing it on behalf of the investors to maximize returns and minimize risks.
In simple words, when you invest in a mutual fund, you are pooling your savings with several other people who do the same. You don’t select particular stocks or bonds; however, the fund manager does that for you. The idea is to earn satisfactory returns over time.
Types of mutual funds
There are several types of mutual funds available in India for various investment goals. Some of the most common ones are:
- Equity mutual funds
Equity mutual funds investment is in equities of companies. The funds are supposed to generate high returns but involve a higher risk too. They are best suited for long-term goals, such as retirement or your child’s education.
- Debt mutual funds
These are fixed-income securities such as government bonds, corporate bonds, and treasury bills. Funds of this type are safer and generally provide more stable returns compared to equity funds. Such funds are ideal for short-term goals or for risk-averse investors.
- Hybrid mutual funds
Hybrid mutual funds are a mix of equity and debt funds. They keep your risk level as well as return balanced by investing in both stocks and bonds. These funds are suitable for those investors who want a little from both worlds: higher returns than debt funds with fewer risks compared to pure equity funds.
How to calculate returns on mutual funds
Now that we know what mutual funds are and why they deserve to invest in them, let us proceed to knowing how to calculate returns on your mutual fund investments.
- Absolute returns
The easiest method of calculating returns is via absolute returns. This method is taken when you have invested for a relatively short time frame, perhaps less than a year or a little more.
The formula for absolute returns is:
Absolute Return = Current Value − Initial Investment/Initial Investment×100
Suppose you invest ₹50,000 in a mutual fund. After one year, the value of the mutual fund appreciation becomes ₹55,000. Your absolute return would be:
55,000−50,000/50,000*100 = 10%
This means you have earned a 10% return on your investment.
- Annualized returns (CAGR)
In case the investment period is more than one year, we calculate the returns by using Compounded Annual Growth Rate. This latter takes into account the time period of the investment and gives you an average annual growth rate.
The formula for the CAGR is:
CAGR = (Initial Investment/Current Value)Number of Years/1 − 1
Let’s say you invested ₹1,00,000 in a mutual fund, and after three years, your investment has grown to ₹1,50,000. To calculate the CAGR:
= 14.47%
- The XIRR is the extended form of the Internal Rate of Return.
If you’re investing regularly, say through SIPs, then the returns must be computed using the XIRR or Extended Internal Rate of Return. XIRR is more complex compared with other calculations since it considers an investment made at different times and computes one aggregate return.
The XIRR usually gets auto-calculated at most online mutual fund sites and in online mutual fund returns calculators, so there’s no point in doing that yourself.
Why mutual funds?
Mutual funds are a great investment, and there is no greater reason why the Indian investor should invest in mutual funds than anything else. Here are some reasons:
- Professional management
The scheme helps you by pooling your money with other investors and placing it in the hands of a professional fund manager to be invested on your behalf. It is very helpful for people who do not have time or know-how for doing this investment themselves. The fund manager’s experience and knowledge are of use when it becomes necessary to make the smart investment decisions.
- Diversification
Mutual funds invest in various stocks, bonds, or other securities. This means your investment is diversified among different companies and sectors, thus reducing the overall risk. Chances are that even if one or two of the stocks perform poorly, others in the portfolio might do well; thus, your returns will get balanced.
- Easy to invest
It’s very easy to invest in a mutual fund. The amount required to start investing is very meager, and various modes, including SIPs, allow you to invest a predefined sum every month. Thus, mutual funds are accessible to everybody without caring for their financial investment capabilities.
- Tax benefits
Some other mutual funds, for example, ELSS, provide you with tax saving benefits under Section 80C of the Income Tax Act. You may earn your money back in taxes too while your investments keep growing.
Factors affecting mutual fund returns
Now that you are calculating returns, you must be aware that there are several factors that affect what you get back. Here are a few to get you going:
- Market conditions
These include, however, equity funds and can be considered to be compared to the stock market. If the market is good then your returns are likely to be high. On the other hand, market shocks tend to leave you in a bad situation regarding returns.
- Expense ratio
Each mutual fund carries an expense ratio, which is the amount charged by the fund house to manage your money. The higher the expense ratio, the greater is the cost to your returns, and hence it’s always better to select funds with a lower expense ratio.
- Investment tenure
As an illustration, the longer you invest the greater returns are because the compound effect works in your favor. Compounding actually means that the earned returns are reinvested, and then you start earning returns on returns. This can see your wealth build up to very huge sums in quite a little while.
- Risk and fund type
These funds come with varying levels of risk and returns, so there are quite a few available. Some equity funds promise higher returns, but they carry higher risk, too. Debt funds promise lower returns with more stability, so one must choose one that matches the risk profile as well as the overall financial goals.
Conclusion
Mutual funds are a great platform for the increase of wealth over time. Mutual funds can offer diversification and professional management with a variety of choices. Whether you are investing to achieve some short-term goal or create long-term wealth, there exists a mutual fund that will help you in the pursuit of achieving your financial goals.
Calculations of returns are part and parcel of mutual fund investment. It will show how one’s investments are doing, making proper decision-making, and staying on course with what should be expected in terms of possible financial achievements. With quite simple techniques – absolute return, CAGR, and XIRR-calculations are extremely easy to calculate how much one’s investment has increased.
As with any investment, research and determination in choosing the right mutual fund will pay back in the long run. Having the right information at the right time and making smart decisions can serve you well in efficiently navigating the world of mutual funds.
