Here’s How to use Investment horizon to choose Mutual Funds:
Is your investing in line with your horizon?
Apart from goal-setting and risk-appetite, there’s one more issue that you need to gain clarity about in mutual fund investing. It relates to the “Investment horizon.”
Investment horizon means for how long you would desire to stay invested in an investment vehicle. It will show the total length of time for which you expect to hold a security or a portfolio.
Simply put, it’s about determining when you want your money back from the given portfolio.
Accordingly, investment horizon can be loosely classified as short-term, medium term and long-term.
Short-term is usually of 1-3 years. The medium term relates to the relatively longer period of say from 5 to 7 years. Long-term is a period of more than 10 years and can extend up to as long as 30 years.
Your investment horizon speaks a lot about your expectations from the investment. Additionally, it has implications on various aspects of investing.
As regards your investment goals, these tend to differ with the horizon. Usually, goals which require relatively lower funding have a shorter horizon. Conversely, goals which entail huge investment are meant to be long term.
Your risk appetite tends to vary with investment horizon. Fundamentally, it’s advised to keep riskier investments like equities for the long term. In the short-run, it’s better to confine yourself to low-risk instruments like debt funds.
Investment horizon weighs heavily on the returns perspective of an investor. The need for income and expected rate of return, it varies considerably with the horizon.
It would be imprudent to expect sky-high returns in the short run. However, you may have higher returns expectations in the long run.
This phenomenon can be supported by several principles.
As indicated above, only low-risk securities are suitable in the short-term. Hence, going by the risk-return tradeoff principle, low-risk securities would generate low-returns. Conversely, high-risk securities would generate high returns.
Investment horizon & mutual fund selection
While shortlisting mutual funds, your investment horizon holds paramount relevance.
Primarily, mutual funds can be open-ended or close-ended. The portfolio holdings of each of these fund categories vary as per the duration. Also, the risk profile is according to the investment period.
When you are investing in any of these funds, matching of the investment horizons is very important. A mismatch may not only lead to non-achievement of goals; but also assuming inappropriate levels of risk than required.
Shorter investment horizon
It is best for investment in liquid funds. Suppose you have created a 6-month emergency fund of Rs 50000. You will get barely 4% interest in a bank saving account.
Instead, try liquid funds. These invest in high-interest generating securities of short duration. You may earn a return of as high as 7%-8% in the short run.
It is meant for balanced/hybrid funds. Imagine you are planning to buy a high-end car after five years. You can invest in balanced funds. These funds invest in both equity and debt securities.
Fund manager intends to earn a return higher than bank FDs in the intermediate term. But, simultaneously he wants to keep a low portfolio risk profile.
Apart from balanced funds, there are other categories of debt funds that you may look into. In case you are interested in close-ended funds, you may go for Fixed Maturity Plans.
These have also known to give good returns over the intermediate term. The only thing is that these can’t be continued beyond the fixed duration.
Arbitrage funds have evolved as vehicles to earn a risk-free return. These play on price differentials of securities in different markets.
Similarly, dynamic bond funds also give reasonable returns by capitalizing on volatile interest rates. The fund manager modifies the fund duration to suit the externalities.
Long investment horizon
It warrants investment in equity funds. If you want to leave a legacy of wealth for the next generation; you may go for equity funds. These can be standalone large-cap/mid-cap/small-cap or diversified.
These may represent severe volatility in the short-run. Small-cap funds are the most volatile of the all the equity funds. The variations of equity fund return even-out over a period of 10-15 years to give you annualized returns of around 12%.
Tax Implications & Exit loads
Your every investment action affects your tax incidence. Be it equity fund or debt fund; both have tax implications on your returns. Unplanned exits may dent your returns owing to higher rates taxation.
The tax incidence is the highest in the short run. The holding period of less than 1 year is regarded short-run for equity funds.
Redemption within 1st year of investment will attract capital gain tax of 15%. However, long term capital gains are tax-free.
In case of debt funds, holding period of fewer than 3 years is regarded as short-term. Short-term capital gains will be added to your income and taxed as per your income slab.
If you redeem debt funds after 3 years, long-term capital gains will be taxed at 20%. In this, you will get the benefit of indexation.
If you have a long-term horizon and fall in the higher tax slab, invest in equity funds. Otherwise, go for debt funds in the short-term.
Exit loads are found in debt funds. Each fund may have minimum duration during which redemption may carry exit loads.
Exit loads reduce your net return earned on the investment. Hence, plan your exits accordingly.
Investment horizon & Systematic Transfer Plans (STPs)
You can use STPs to suit the length of the investment horizon.
Consider a situation wherein >70% of your retirement planning portfolio is made of equities.
As you approach retirement, such an allocation may seem risky. Sudden volatility immediately before retirement may wash out the returns completely.
As your horizon reduces, you need to adjust the portfolio accordingly. You may initiate an STP at this point.
In this, more of the portfolio would move from equities to debt. Thus, you will be saved from losing out to market volatility.