An article by Vinay Kumar for making his friends understand why it is important to invest in mutual funds and how mutual funds delivers inflation beating returns that not only saves tax under 80C but returns are tax free as well.
This is not a regular guest post like we see on other blogs written solely for the purpose of getting links to writer’s website. Vinay Kumar has written this article for making his friends understand why it is important to invest in mutual funds.
Vinay Kumar emailed me asking if he can share a document he has written about Why Mutual Funds? I could sense that his voice of asking me to read his article sounded skeptical but he managed to write that email and I am glad he did that. His document was more of an elaborated points as it was written to make his friends understand why mutual funds. I asked if I can publish his work on my blog and he generously not only allowed me to publish it but allowed me to me convert it from his points based document into an article.
I am open to all my blog readers for views on everything investing. So if you have something that you have written but are afraid of making it go live you can let me know. I will be more than happy to help you convert them into an article. Also note that some of his points you will see my views in Italics.
So without much of an edu let’s Vinay Kumar voice begin.
Mutual Funds Delivers Inflation Beating Returns
Inflation is of the order of 8% on an average for quite some time now. If your money is invested in fixed deposits, what are your absolute returns? On top of that you need to pay tax on your annualized return (Tax need to be paid on the interest earned through fixed deposit). Is your money really growing with respect to inflation? Answer will be No.
So what is the solution to the above problem and how can you earn inflation beating returns?
Mutual funds come to your rescue. Mutual fund is the investment vehicle that gives inflation-beating returns. It is proved time and again beyond doubt. All the top rated mutual fund schemes viz. ICICI prudential blue-chip focused equity fund, HDFC Equity, HDFC mid-cap opportunities, IDFC premier equity, HDFC Balanced, Canara Robecco Equity tax saver etc. have given annualized returns of the order of 25% to 40% over a 3-5 year period (long term investment).
Shabbir: Just to put numbers into perspective. The best rated funds has given an average return of 10% for 5 year time frame that includes the 2007 fall easily beating returns from fixed deposits.
Long Term Mutual Fund Returns are Tax Free
If the investment in mutual funds is held for more than 1 year, then such investments are called long-term investments. And the gains achieved through such long-term investments are called long-term capital gains (equivalent to interest earned in fixed deposits) but such long-term capital gains are not taxable.
For example: You have invested ₹ 1000 in X Mutual fund scheme on 01-Jan-11. It has grown to ₹ 1200 by 02-Jan-12 and you have redeemed your investment. The profit that made by you i.e., ₹ 200 is the long-term capital gain and it is tax-free. Where as in the case of fixed deposit, the interest earned is taxable which brings down your net returns.
Mutual Funds compared to Fixed Deposits
Mutual funds have better return on investment compared to fixed deposits for longer duration of investment period. Mutual fund schemes have consistently delivered far better returns than fixed deposit schemes over a 3-5 year period. What returns you expect with Fixed Deposits? Anywhere in between 8.5% to 9.5% annually. If the same investment is in mutual funds, you can easily beat that returns by a big big margin.
ELSS Mutual Funds
ELSS funds or Equity Linked Saving Scheme funds are Tax saving mutual funds where user can Save Tax under section 80C as by investing in mutual funds.
ELSS Funds have a lock-in period of 3 years and have multiple benefits.
- Save tax under section-80C.
- Better annualized return over NSC Certificates.
- The return on investment is tax-free.
SIP stand for Systematic Investment Procedure where you invest a certain amount after a certain period of time (normally a month) in a given fund.
A SIP of ₹ 2000 in a mutual fund scheme that’s NAV (Net Asset Value is the value of each unit of a mutual fund scheme) is ₹ 100 in that month on your SIP date. Then you are purchasing 20 units (₹2000/₹100) of that mutual fund scheme. NAV depends on the market value of the shares prices in which the mutual fund scheme invests. So the NAV of a scheme varies with the market. And in the next month if the NAV reduces to ₹95, then you can purchase 21.052 units (₹2000/₹95). And in the next month if the NAV increases to ₹105, then you can purchase 19.0476 units (₹2000/₹105). So the number of units purchased by you varies with the variation in the scheme NAV. And your purchase price averages out over a period of time.
SIP route results in disciplined investment approach irrespective of the market movements and is one of the best method to build wealth. We all know investing early is really really important and you can get started investing early with as low as ₹ 500 per month with many mutual funds through SIPs.
Market will remain low during most time of the year and it peaks & remains high for a less time i.e., only for a few months. Buy cheap when the market is low. If the market is falling or low, people start running away. But it is the right time to get into market. That can be done in a disciplined manner through SIPs
Shabbir: RD or recurring deposit is something that is more like SIP in Mutual Funds.
Investing or Saving
Let’s me start with a question. Do you want to invest or save your money? You may ask what’s the difference between investing & saving.
- Investing is putting your money in avenues such that your money can grow and help you increase your buying power.
- Saving is as simple as not spending.
If you invest in traditional fixed deposit or bonds, you are saving your money, not investing. For example – If you are investing ₹ 100 in a fixed deposit for 3 years and the average inflation is 8% for the period. And the interest rate per year is 8.5%. The money will grow to ₹ 127. But you need to pay a tax on the interest earned i.e., ₹ 27. Hence, post-tax earning is ₹ 24. However, as per inflation, the future value of ₹ 100 is ₹ 125. So, is your money really growing? Is your buying power growing? No. You are just saving your money (By not spending & putting it in a fixed deposit which can’t give inflation beating returns).
Now let’s see what happens if the same ₹ 100 is invested in a mutual fund scheme. If the scheme gives an annualized return of 25% (all good schemes have given such returns over 3-5 year period consistently), then your money will grow to ₹ 195. And the profit earned in mutual funds is tax free if the investment is kept for more than 1 year as I have already mentioned above. Considering inflation your investment has gone up by ₹ 70 (₹ 195 – ₹ 125).
Coming back to the same question. Are you investing or saving? Is your savings and investment increasing your buying power?
Another important advantage that inherently comes with mutual funds is the diversification. By default your asset is diversified into good stocks from varied sectors based on your choice of fund.
Investment through Mutual Funds is less risky as compared to direct investment in stocks (Shabbir: Not completely risk free but less risky) because you are investing in a portfolio of stocks, where even if 1 or 2 stocks under-perform, the overall portfolio returns will still be good because of the other better performing stocks in the portfolio of fund.
A professional fund manager manages equity funds and you can avail a fund manager service at a very low cost compared to hiring them individually to manage stocks for you.
Invest more in Equity when you are young and as you grow older, churn the portfolio and move towards more secured returns. Share your views in comments.