t's annoying. And confusing.

First, there are mutual funds. Then there are more mutual funds.

Each one comes with its own bag of schemes (right now, there are more than 450 such options on the table).

To top it all, people who invest in them speak a strange language that includes words like NAV, load/ no-load and open/ close-ended (we will de-code this jargon for you in the days to come). 

But, for now, where do you begin?

You start by understanding that mutual funds come in various sizes, shapes and flavours. You need to pick one that suits your palate.

Let's check what's on the menu.

For starters, there are debt funds, money market funds, balanced funds, equity funds, sector funds and index funds.

All you need to make the right choice is to know what to look for. By figuring out where the fund manager invests the fund's money, you will be able to zero in on the type of fund best suited to you.

Basically, there are three broad types of funds from which you can take your pick: Debt, equity and balanced.

Debt can be good

The first step is to understand what a debt instrument or a Debt Fund is. A classic example is a bond.

Let's say IDBI comes out with a bond issue for three years. You decide to invest Rs 50,000. That means you are loaning IDBI Rs 50,000 for three years.

IDBI will pay you interest at the rate of, let's say, seven percent per annum during these three years. At the end of the three years, you will get back your original amount of Rs 50,000 as well as the amount earned as interest.

Some bonds are listed on the stock exchange and are put under the debt segment (as opposed to the equity segment which refers to shares). These bonds can be traded (bought and sold like shares). But, since the amounts involved are huge, it is difficult for someone to trade them on an individual basis. Financial institutions or mutual funds, on the other hand, are able to do so because they buy and sell huge amounts like 50,000 bonds at a time.

The prices of these bonds will change when they are listed (just like shares) and mutual funds and institutions aim to make a profit by buying and selling them.

For instance, you may buy a bond for Rs 100. That is called the face value of the bond. But when the bond is listed, many others may want to buy it and may be willing to pay Rs 110 for it. Or not too many may want it; those who do may be willing to part with only Rs 90 for it. So the price of the bond will vary, but the face value remains the same.

One factor that leads to the bond price moving up and down is the interest rate. As interest rates rise and fall, they will affect the price of the bond (we will explain this in detail at a later date).

In a debt fund, the fund manager will mainly buy debt instruments which are fixed-tenure (fixed time frame) and fixed-return (fixed interest rate). That is why they are also called income funds. Examples of such instruments are bonds, debentures, fixed deposits, government securities, Certificates of Deposit, Treasury Bills and Commercial Paper.

Your call

Would you agree or disagree with the following statements?

1. You want a higher return than what you get from a fixed deposit.

2. You don't want the hassle of going and buying bonds/ debentures/ fixed deposits of various companies.

3. You want to take as little risk as possible.

4. You think shares are only for traders

If you have agreed with at least two of the following statements, you will be most comfortable investing in a debt fund.

Take a chance on shares

Unlike debt instruments, equity (shares) has no fixed return and no fixed tenure.

Equity Funds aim at providing long-term capital growth. Which means, when you buy into such a fund, be prepared to stay in it for at least three years to see any appreciation in the value of your investment.

This is an alternative for people who want to invest in shares but do not want to directly buy them. They would like a professional to do the buying and selling.

Here, the fund manager will buy and sell shares of various companies in different sectors (industries like cement, infotech, biotech, etc). As prices fall and rise, he will buy and sell to make a profit.

The good thing is that an individual need not be concerned about buying shares of different companies in various sectors, he or she can buy into a mutual fund and the mutual fund manager will do the needful.

Your call

If you really want to participate in the share market, then an equity fund is your best bet. But remember, equity is risky because you never get a fixed return. It also depends on whether the share is bought at the right time (when the price is low) and sold at a profit (for a higher price). So the risk remains -- you could make a profit or you could lose.

Balance your risk

The name says it all. The Balanced Fund manager will balance the money between equity investments (as in an equity fund) and debt investments (as in a debt fund).

He may put half the fund's money in debt instruments and half in equity (shares). This is not a hard and fast rule and it could vary. The fund manager has the option of tilting more towards debt if the equity markets are not doing too well and vice versa.

Your call

If you would rather sit on the fence, then consider a balanced fund. Here, the equity risk is balanced by the debt investments. A balanced fund will try to promise higher returns than debt funds but lower returns (and lower risk) than equity funds. They seek to give you both: growth and safety.

Alternately, you could put some of your money in a debt fund and some of your money in an equity fund. If you are doing this, avoid investing in a balance fund.

Closing note

It would be wise to remember that no mutual fund will give you a fixed return. If fact, you may not even get a return if the fund manager doesn't do his job well.

Having said that for the mutual fund industry as a whole, remember there are some funds that are more risky than others. Income funds are less volatile and less risky when compared to equity funds, but equity funds have the potential to give the highest return.

Each debt and equity category can be further divided on the basis of their risk factor (more on this later). If you are certain you want a fixed return, then it would be best if you invest in for a fixed deposit or bond and bypass mutual funds entirely.

Next: How to select an equity fund