Module 8: Key Factors to understand before making future investments
Now that you have an introductory understanding of the basics of a mutual fund, it is important to understand a few things. These things may not be exciting to talk about but we still have to do it because they are essential.
1) Emergencies:
Think of any unexpected events in your life such as job loss, medical issues such as hospitalization etc. These situations are called emergencies - they are unannounced and can be financially draining. The important thing is to be prepared to face such a situation. Hence, it helps to reserve a certain lump of money to take care of yourself and your family members in such scenarios. There is no right or wrong number here. It is essential for you to sit down with your family and have a conversation with them about how much money is needed that can be stashed away as emergency funds. A common norm followed is that your 6-month or 12-month income/expenses can be reserved as an emergency fund.Once you have decided this corpus, you can park it such that you can access it immediately when you need it. A simple fixed deposit (FD) or even a savings account may also help here. Also for securing yourself and your family members it is important to have both a health and life insurance plan irrespective of your current age. This can take care of unforeseen events and expenses.
2) Borrowing Money:
Every time you borrow money, it comes at a certain cost - this is called an interest rate which is the percentage of the amount borrowed that you pay over and above the borrowed amount. Before you borrow, it is important to understand how much capacity you have to borrow. For example, if your monthly income is ₹. 1L, then this is how your finances may look like:
The above example in the table is added for information purposes only.
This ₹ 20,000/- is what you can afford as a monthly installment amount to repay your borrowing. Anything more than this money will potentially disrupt your financial situation. Hence, you can estimate the amount for which you can avail the loan based on the monthly installment using any online EMI calculator.
3) Inflation:
It's a broad indicator of how much more expensive the things that you consume have become. It can also be termed as the increase in the overall cost of living in a particular country or city. When you plan for your investments to achieve a financial goal which we will cover in the next module, it is important to have a look at the rise in the prices over a period of time. You can have a look at how inflation affects you in the table below:
Calculation done using the formula → P(1+R)^N, where P = principal amount and R = rate of inflation and N = time period.
4) Risks:
Investing in any mutual fund scheme involves various risk factors like we mentioned in Module 1.
Here are a few of them below:
a) Standard Risk Factors: The standard risk factors are the risks that all mutual fund investments are exposed to such as:
1. Mutual Fund Schemes do not guarantee any returns
2. Past performance does not guarantee future performance of any Mutual Fund Scheme
3. The value of your investment in a mutual fund scheme may go up or down
b) Specific Risk Factors:
These are risk factors that are specific to certain categories of schemes:
Risks associated with investment in equities →
1. Risk of losing invested money/Principal:
Investments in equities/stocks involve a degree of risk and you should not invest in the equity schemes unless you can afford to take the risk of possible loss of invested amount/principal.
2. Sector specific Risk/Industry specific Risk:
Stock prices can go up or down due to sector/industry specific events. Mutual funds that invest in these stocks also carry the same risk.
Currently we have only covered a few of the risk factors associated with equities. Apart from these risk factors, there are a number of other risk factors associated with debt schemes too. You can read more about these risk factors here.
Also every mutual fund scheme will have different risk levels associated with it. To understand how risky your scheme is, you can check the riskometer of the scheme. An example of the riskometer for a ‘Very High’ risk scheme is shown below:
The following values are assigned on basis of the risk-o-meter of the scheme:
5) Savings:
This is probably the most important factor to consider before you consider investing in any instrument. Getting into the habit of saving money at an early stage helps you observe your own behaviour when it comes to money. Even saving small amounts regularly can help build consistency and discipline which are key traits when it comes to investing as well. There is also a psychological angle associated with this. By building a savings habit over a period of time you’re creating peace of mind since you are now in control of your finances and not the other way round.
6) Diversification:
The act of splitting your invested money between the different types of mutual fund schemes described above in module 3 is called diversification.If we could predict which type of mutual fund scheme would give the best returns, we could simply invest all our money in that one. But the truth is, no one can predict that.
To protect yourself and manage risk, the best approach is to invest a little money in different types of schemes instead of relying on just one.
Key Takeaway:
Mutual Fund Schemes do not guarantee any returns and past performance does not guarantee future performance of any Mutual Fund Scheme.
Task:
Please decide on the emergency fund corpus required to cover yourself and your family. There is no hard and fast rule here - this is something that you can decide based on a discussion with your family by going through all possible scenarios.
Previous Module
Next Module
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
An Investor education and awareness initiative by Zerodha Mutual Fund.
