Mutual Funds: Balancing between equity and debt funds

As equity funds primarily invest in the equity shares of the companies, profits of these companies can be volatile due to the ever-changing market environment in the short run and thus the price of the equity share also fluctuates in the short term.

By A P Singh

An individual investor may have multiple financial goals in his/her life with different investment horizons. Risk-taking capacity and willingness to take risk among investors are different, financial goals are different depending on financial situations and life stages of an investor. All these aspects can be dealt with a variety of mutual funds available in the market.

Mutual funds can be categorised on the basis of their structure or investment objectives. When categorised on the basis of investment objectives, equity funds and debt funds are popular among investors. Investors may choose among equity funds, debt funds, or a combination of both for achieving their financial goals. However, the task to choose between equity and debt can be a daunting one. There are different parameters on the basis of which these funds can be compared.

Here’s how one can create a right balance between the two to meet his/her financial goals.

Equity & debt funds
Equity-oriented mutual funds invest primarily in the shares of companies and related securities such as derivatives (i.e. futures and options) which trade in the stock market. Debt funds invest in fixed income securities like debt and money market instruments. Debt market instruments include non-convertible debentures (NCDs), corporate bonds, government bonds or G-Secs, etc. Money market instruments include treasury bills (T-Bills), certificates of deposits (CDs), commercial papers (CPs), etc.

The primary objective of investing in equity oriented mutual funds is either capital appreciation or getting dividends. Accordingly, growth plans of equity funds reinvest dividends in the market while dividend plans pay out the dividend to investors. The interest earned by a debt fund from its portfolio can either be distributed among investors or added to the fund assets, leading to an increase in NAV.

Equity-oriented mutual funds have the potential to offer high returns but the risks are higher. Debt-oriented mutual funds invest in fixed income securities and thus offer relatively lower but stable returns when compared with equity funds.

Short & long-term funds
Debt funds are suitable for the short-term and can be used as an alternative to fixed deposits and deposits in the saving bank account whereas equity funds are for the long term and suitable for investors with high to moderately high risk appetite. Equity funds may help you in reaching your long-term financial goals whereas debt funds are suggested for your short to medium-term goals. Let us understand the logic behind the same.

As equity funds primarily invest in the equity shares of the companies, profits of these companies can be volatile due to the ever-changing market environment in the short run and thus the price of the equity share also fluctuates in the short term. But in the long run, they tend to be less volatile and move in line with the profits earned by the company. Hence, if you are investing in equity mutual funds, they are less volatile in the long run; say 5, 7, and 10 years. Debt funds on the other hand offer stable returns in the short duration and the risk is low. Thus, the short-term goals having a duration of three to five years can be fulfilled with the help of debt funds.

Creating a Balance
Select funds based on what you expect from the investments. For short-term investing and lower risk, debt funds are apt whereas for long-term goals, equity funds are a suitable choice. However, when we have multiple goals, striking a balance between these two may be confusing. While creating a portfolio, you may follow the ‘100 minus Age rule’ for deciding the exposure towards debt and equity. This rule states that exposure towards equity should be equal to the difference between 100 and your age. So, if your age is 30, then equity investments in your portfolio should be 100-30, i.e., 70%. The same rule can be applied here also while selecting between debt funds and equity funds.

Some important parameters to consider while choosing between debt funds and equity funds are the time horizon, risk required to achieve your goal, risk capacity, and risk tolerance. We recommend you select both debt funds and equity funds for diversifying your risk. This will help you in achieving your multiple goals, both for the short term and long term.

The writer is director, Amity School of Insurance, Banking & Actuarial Science, Amity University