You ask, we answer. Our responses to selected customer questions, which we think would benefit all our readers.
Updated by Clarified Team
I am a 52 year old risk-averse investor, with over 65% of my corpus in open-ended debt mutual funds. But I'm not quite sure how safe these funds are. Are there any risks that I need to be aware of?
The level of risk in your portfolio depends on the type of debt funds you hold. For the most part, debt funds are categorised based on the type of investments they make, and the average time to maturity of the cash flows from those investments (macaulay duration). Accordingly, two primary risk factors associated with debt funds are credit risk and interest rate risk.
Credit risk implies the inability of the debt issuer to make timely payments to the mutual fund. There could, of course, be an actual default as we saw with IL&FS. However, the Net Asset Value (NAV) of your mutual fund could also be impacted by a rating downgrade, which reflects a deterioration in the debt issuer's ability to make future payments. Where your financial goals are concerned, we recommend that the average credit rating of your debt fund portfolio should be AAA equivalent.
Interest rate risk is the impact of interest rate movements on your mutual fund's NAV. Simply put, as interest rates go up, the value of debt securities falls, and vice versa. However, the extent of the impact of interest rates depends on the type of debt fund. Ultra Short Duration Funds, which have a macaulay duration of 3 to 6 months, are impacted way less than Long Duration Funds, which have a macaulay duration of more than 7 years.
There are, of course, a few other things you need to be mindful of. Important among them is the AUM (assets under management) of your mutual fund. Most of the investments in debt funds are held by large institutions; redemption pressure from just a few big investors can force a very small debt fund to prematurely liquidate a large part of its holdings. This could adversely impact the returns of the remaining investors. So it's a good idea to stay away from very small debt mutual funds.
I started investing in two multi-cap equity mutual funds last year. The return generated by one of the funds exceeds the return generated by the other fund by 3% points. Is it a good idea to move all my investments into the fund that delivered higher returns?
While it is a good idea to periodically review the performance of your mutual funds, churning your portfolio frequently based on the returns generated during the previous year is by no means prudent.
Notwithstanding that the difference in returns alone could shroud the impact of portfolio risk and investment style (value vs growth), short-term returns offer no insights into the likely future performance of a mutual fund. Worse, by frequently moving across mutual funds you are more likely to incur exit loads, pay capital gains tax, and miss out being invested for at least a few days every year. Collectively, these factors could severely undermine your portfolio returns.
That said, there are often good reasons for moving your investments out of a mutual fund. These could include a change in the investment objective or investment strategy, a new fund manager with underwhelming credentials, deficient performance over an extended period of time, deviation from the stated investment objective, and adverse SEBI order against the mutual fund, among others.
I'm passionate about the automotive industry, believe in the growth prospects of Bajaj Auto and Mahindra & Mahindra, and I'm planning to invest a sizeable portion of my portfolio in these two stocks. Should I?
Nope. Not a sizeable portion of your portfolio, at least. Here's why:
First, just two stocks is not diversification enough. A well diversified equity portfolio has more like 30 stocks; stocks that aren't exposed to the same risk factors, i.e. not concentrated in the same industry at the very least.
Second, good future prospects of Bajaj Auto and Mahindra & Mahindra would mean very little if they are already priced in. The stock price of a company depends on how well the market participants believe the business would do in the future and the cash flows it would generate. If the future performance falls short of the expectations that the stock price reflected at the time of your purchase, your investment loses value, and vice versa. The average investor is almost entirely incapable of making this determination accurately while picking stocks to invest in.
Third, if and when the performance of your investment begins to lag and selling is the right course of action, you are unlikely to be the first one out of the door. By the time you do act, your investment could lose a fair bit of its value.
So, if you must invest in direct equities, invest a relatively small amount that you wouldn't mind losing if things head south.
I've come upon some extra cash. How do I decide between paying off an outstanding loan early and investing for retirement?
This decision depends upon the effective rate of interest on your loan (i.e. net of tax benefits, if any) and the post-tax returns you expect to earn on your investments. If the effective rate of interest is high, as is usually the case with personal loans and credit card debt, then you should opt to pay off the loan as soon as feasible. If, however, the effective rate of interest is lower than what your investments could earn, it may be wise to invest the surplus cash toward your retirement.
That being said, if outstanding debt makes you uncomfortable in any way, we'd suggest that you prioritise paying off your loan balance irrespective of returns you expect to earn on your investments.