Here’s what mutual funds (MFs) are, and how they work.

Let’s say you and I had some money, about 1 lakh rupees each. And we have 8 other friends with the same idea. We all decide that we need to invest this in stocks, but we don’t have the time or energy to do research, tracking, buying selling etc. So we hire a manage who has the right experience and tell him - “Look, you can take up to 2.5% of the total value every year as your fees, but you buy shares that will grow over time, and sell when the time is ripe, etc.”

Ten of us have now put in a lakh each and the total corpus is Rs. 10 lakh. We decide that we will issue ‘units‘ to denote our interest in the fund, so we issue 1 lakh units at Rs. 10 each. (It’s like chips at a casino). So each person gets 10,000 units, corresponding to an investment of Rs. 1 lakh.

The manager, who is quite experienced and informed, makes stock-buying decisions based on what we, the investors, decided up front - i.e. only large cap stocks, or only technology stocks, at least 90% invested (only 10% cash) etc.

As the stock values grow, so does the total corpus value. Let us say the value has gone up to Rs. 15.6 lakh in two years. Now we have to pay the fund manager 2.5% every year, which works out to Rs. 60,000 for two years. That leaves Rs. 15 lakh. So the value of the 1 lakh ‘units’ is now Rs. 15 lakh, meaning each unit is now worth Rs. 15. This is called the ‘Net Asset Value‘ or the NAV. Since each of us has 10,000 units, our individual value is Rs. 1.5 lakh.

Now I decide to take a trip to Singapore and spend Rs. 75,000. So I sell half my units at the current NAV, meaning I sell 5000 units at Rs. 15. To give me money, the fund manager sells some stocks, and now the total corpus is down to Rs. 14.25 Lakhs. But that will again grow with time, but I will see lesser growth than anyone else in the fund because I have only 5000 units and while the others have 10,000.

One day, when the NAV is Rs. 15 per unit, the fund manager decides the market is going to fall. So he sells half the holdings. Now there is half the money in stocks and half the money in the bank. So the manager gives us the money in the bank as a ‘dividend.’ Let’s say he decides to give Rs. 5 per unit as a dividend, for 1 lakh units (ignore my selling bit for a moment here). The dividend would then be 50% (since the initial value of the unit was Rs. 10; your initial value stays the same even after the dividend)
So, each one of us get Rs. 50,000 as dividend. But now, the total corpus has fallen by Rs. 5 lakhs! The NAV (total corpus divided by no. of units) is going to fall by Rs. 5 per unit. So a dividend for this “mutual” fund is the same as no dividend - you get money, but your fund value goes down.

This is how mutual funds work.

Now funds can be misused (manager can run away etc.). Hence, the government has regulations for organised mutual funds. They must have a sponsor (usually a bank), a set of trustees (some independent), and an asset management company (AMC), which appoints a fund manager. Promotion of the fund is done through agents who are recognized by the Association of Mutual Funds in India (AMFI). These people get commissions to sell the mutual funds, and therefore mutual funds carry an ‘entry load’, which is usually between 2 to 2.5%. (This is apart from the AMC/Fund manager fee)

How to invest?
Go to your bank, or go to mutual fund sites online. They will give you forms to fill and you can write a cheque to the fund. The fund will then give you a “holding statement” with a folio number.

Selling (Redemption of units)
You can use your folio number to sell any of your units. Funds release their NAV regularly, sometimes daily. When you sell, it will be at a certain day’s NAV (usually the day you sell or the next working). And usually, you get the money in two-three days.
Some places allow you to invest online - Reliance Mutual Fund does that. HDFC bank’s Netbanking and ICICI Direct too give this facility.

Types of Funds
Mutual funds can invest in anything - not just stocks. There are those that invest in government bonds, fixed income securities, real estate, indexes, part debt-part equity, etc. Read the offer document of a mutual fund carefully before you invest, see what the fund will invest in, and how much.
There are open-ended and closed-ended funds. If you can buy anytime and sell anytime, the fund is open-ended. Closed-ended funds can only be sold at or after a certain date.

Inflation is a money eater that reduces your purchasing power. For instance if the average rate of inflation is 8%, you need to make sure that your investments are earning a minimum of 8% or more, post-tax. Let us assume an investment portfolio of Rs. 1, 00,000, earning returns at 10% and inflation at 8%. The returns in this case would be Rs. 10,000 gross annually, with the net after income tax Rs. 7000 (Assuming you are in the highest tax bracket of 30%). Now if you account for the 8% inflation specified (8000, or 8% of Rs. 100,000), you are left with Rs. -1000 (Return of 7000 minus inflation of 8000)! The best way to grow a retirement corpus is to have a diversified investment portfolio according to the asset allocation designed for your risk profile. An ideal one would be 40% equity (blue chip), 50% debt, 5% gold, and 5% cash. Equity would help appreciate the retirement corpus. Debt investments would provide for regular income and gold would act as a hedge to inflation and equity turmoil. The recent equity market downturn was the perfect example for gold to stand out as a surge. Selective equity investments made for the long term are more often than not investments with high returns.

Equity: Do not sell blue chip stocks when the value increases. This should not be done when you planning for retirement. These stocks provide for the regular incomes by the way of dividends. At the same time if the dividends paid by the companies increase, it will reflect positively on the stock price too. The most crucial aspect that we never consider in an investment is the dividend that companies pay. We always look at just the capital appreciation. Dividend income in India is tax-free. The dividend payouts by all good companies grow proportionate to the growth in the net profit. It means that if you stay invested, your equity dividend income will keep growing year after year, compounded. If you think that the return on your capital is tiny compared to your investments, just be patient and watch out for a few years. Lets assume that your company’s dividend payout grows 20% year on year, in 10 years your dividend income will jump by more than 6 times and in 20 years it will go up by nearly 40 times. And if you consider the occupational windfall gains like rights and bonus issues, your dividend income goes up in compounding multiples over a period of time.

Your Investments should perform better than the market: Is it easy? Yes quite possible. The Bombay Stock Exchange has approximately 3000 shares listed on it but its index, the Sensex, is a weighted average representation of just 30 stocks. So, if the Sensex falls it is an indication that the heavy weights from the 30 stocks fell; not all the 3000 stocks. If your investment portfolio is to beat the Sensex, they will need to have a Beta more than 1. The Beta is a measure of sensitivity of a scrip movement relative to the movement of the benchmark index (in this case, the Sensex). A Beta of 1 means that for every 1% change in the index, your scrip moves by 1%. The caution here is that when you have a Beta of more than 1, your investments will also fall faster than the Sensex fall. Investments in stocks can be very rewarding but with high risk.

If you lack knowledge let mutual funds take care of it: I believe most of you investors who lack knowledge should rely on mutual funds, not individual common stocks. This is not because I think your performance will not be better; rather I think it will be easier for you to operate and will allow less potential for a catastrophe. Investments in mutual funds are managed by professionals who understand and study all the critical aspects before investing your money. This will help in proper diversification, but be sure of you choosing the right scheme to invest in as per your risk profile and aspirations.

Let your debt investments comprise of Government securities and highly-rated bonds (AAA): The most important component in a diversified portfolio is investment-grade fixed income. High-grade bonds and full-faith-and-credit-pledge government securities are the most reliable fixed-income counter balancers.

The balance between debt and equities is a function of (1) your age - the younger you are, the larger your equities percentage; (2) your financial resources; and (3) your need for current income. No two investors have exactly the same risk/reward profile.

Once your debt investments are in place, you need to make adjustments and additions from time to time depending on your changing needs and available new cash for investment. But you should keep rebalancing the portfolio according to your asset allocation strategy once a year.

Biggest mistake is investing based on events: You should never make investment decisions reacting to short term economic indicators or performance. You should build long-term wealth by investing in good companies with strong balance sheets and a history of paying and increasing dividends, and then you remain patient. You don’t jump in and out of stocks based on quarterly earnings reports. Base your investment program on business cycle trends, not market noise created by events.

You should not make many changes to your portfolio in the course of an average year. You should add money to some positions and tinker with others. You should not run from one idea to the next each time the economic wind changes direction.

I would like to urge all the investors reading this to begin weeding out your portfolio’s deadwood. Simplify and organize your investing, and practice the basic rules. As you start to see the profits rolling your way, you’ll be glad that you took the time to read this article to lay a solid investment foundation.

Kirtan Shah, a Certified Financial Planner, is a partner at AmbestinQ Consultancy Services.