What is it that makes mutual funds such an attractive investment option? Here is a look at the basic factors that are necessary in a sound mutual fund, and some dos and don'ts you must keep in mind before signing up.

Understand your expectations and the risk involved

Before deciding to invest in a mutual fund, you need to have a clear idea about what your expectations from your investment are (how much you expect your money to grow) and whether you are comfortable with the level of risk involved (how much of its money does the mutual fund invest in the stock market).

It is important that you are clear about the risks you want to take, so that you are not disappointed in the long run.

Think first, choose later

Understand what you need the money for, and let that decide the future course of your investments. Let the risks that the fund takes match the risk that you are comfortable taking.

Here are some steps that might help you pick the right funds:

~ Carefully assess the portfolio to check for the sectors it is focusing upon. Choose a fund where your level of comfort with their preferred sector is higher.

In an ideal scenario, choose a fund that does not have a heavy focus on any particular sector; this cuts down the risk the fund is taking.

~ Understand whether your fund subscribes more to the 'value philosophy' or the 'growth philosophy'. This will give you an impression of the nature of risks the fund will be taking in the future.

It is probably a safer investment to choose a mutual fund that does not buy and sell stocks too often if you are looking for a long-term investment and stability. This is also known as the 'value philosophy'.

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If you are comfortable affording a higher risk and choose to ride the markets, then you might opt for a fund that makes the most out of current booming sectors. This is the 'growth philosophy'.

A bird in hand...

Most investors are restricted by the degree of risk they can take with their investments. Give good thought to your investment process and also to the time horizon of the intended investment (the amount of time you are willing to give to the intended investment to grow).

Don't change mutual funds just to make a quick buck. Patience pays in the long run. If you stick with a particular mutual fund scheme for more than two years, the chances of earning a decent profit on it increases.

However, if you often sell units of one scheme to buy units of some other scheme, you may end up paying more in terms of fees than earning any profits. Instead, stick to a few funds that you think will give you good returns.

Mathematically too, the chances of making money are far higher with investing small amounts regularly than with speculation. Remember, there is no way of perfectly timing the market (selling when the markets go up and buying when they fall; no investor has ever been able to succeed in this department). Unless there is a compelling reason, exiting a fund might not be the prudent choice.

Avoid putting all eggs in one basket

As a rule, always diversify the risks associated with your investments no matter what your ability to take risks may be. For instance, assume you have invested Rs 100,000 in a mutual fund scheme. And it would not make any difference to you even if the value of your investments come down to Rs 50,000.

If this is your risk-taking capacity then you will be better off by investing Rs 50,000 in two different schemes, say one in an equity scheme and the other in a debt scheme. This will help you manage your risks better.

A few pointers to cutting down on risk are:

~ Average out the risk in each category; invest in different asset classes like equity, gold, real estate, commodities etc.

Equity investors would cut down on risks by investing a portion of their funds in debt. Diversifying even within a class like either debt or equity might be prudent.

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~ Split your investments across fund managers. Every fund manager has his own areas of strength when it comes to investing. There is no 'ultimate fund manager'.

~ More often than not, the quirks in the market decide who ends up maximising the returns. This will cut down on your profit margins a bit, but will also heavily bring down the risk.

Success is nine parts observing, one part investing

There are merits to studying and following the markets regularly.

If you do not plan to invest for the next two months, it does not mean you should ignore the ups and downs in the markets for that period. You can never be sure when to enter or exit the market, but you can better your chances by being systematic.

The basic philosophy of rupee cost averaging would suggest that if you invest regularly through the highs and lows of the market, you would stand a better chance of generating higher returns than the market for the whole duration.

Systematic investment plans, SIPs, offered by all funds helps you invest regularly. Simply issuing post-dated cheques to the fund takes care of most of your worries. In the case of a majority of funds these days the amount is directly debited electronically from your account.

There is no substitute for research

Regardless of the investor category you belong to, it is important that you have your basic research in place.

This is how you should go about your research systematically:

Understand all aspects besides just the risks associated with your investments. Get information on the growth in the sector, government policies, FII inflow and any information that makes you better informed. Remember, in the stock markets, information is where the money is.

Ask intermediaries in case you need easier information.

Research also gets you in touch with varied fund managers with diverse expertise, which might help you invest in more diverse stocks.

Which is the right fund for me?

Debt funds have lower returns. It is of higher importance to find funds that charge a low fee, as the fee charged eventually goes from the pocket of the investor.

Funds can be utilised in saving tax. Investors of equity should use the dividend payout option. This is since all dividends are currently tax-exempt in India, and this will help in reducing tax-liabilities.

Debt investors should avoid the payout option, as they will be taxed dividend distribution.

If the market enters a bearish period, equity investors can minimise losses by switching to debt funds. And it is never a problem to switch back to equity once the equity markets start rising.

When to throw in the towel?

On meeting with the initial expectations of the fund, you should immediately book profits, that is, sell your units and take home the profits made. At times, it may not be advisable to continue with the current fund.

Some of these pointers may help in deciding when to quit:

~ In case the fund is not performing relatively in the long run. If a fund has not performed as well as most of its peers in the past, then quitting might be an option worth exercising. When comparing funds, however, ensure that comparisons are drawn between parallels and across the same category. For example, do not compare debt funds with equity funds.

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~ Changes in the Asset Management Company (one mutual fund company buying out another, leading to a change in the management and the fund managers), open-ended funds changing to close-ended funds (in open-ended funds, investors are free to sell their units anytime but in close-ended funds investors cannot sell their units for a minimum period of time decided by the fund running that scheme) and any change in the premises from the offer document might be reason to quit (like a fund changing its objective from a debt fund to growth fund).

~ Significant rise in the fund's expense ratio leading to lower returns.

~ In case a fund does not comply with its objectives. For example, if some diversified equity funds had large exposures to ICE (Information technology, Communications, and Entertainment) sector scrips, then it adds to the volatility and also defies its objective.