Money Plants

Sunday, February 05, 2006

Dummies guide to Mutual Funds

A mutual fund is just what it is named - a fund that is operated by mutual contributions. Here is a story for you.

Sachin has a sum of Rs 1,000 to invest in equity shares. He picks up the latest copy of ET and looks up the share prices of good companies. Here is what his research reveals:

Tata Steel Rs 400
Infosys Rs 2000
ITC Rs 100
Ranbaxy Rs 300
HDFC Rs 1000
(all prices per share)

With his outlay of Rs 1,000, he can buy a couple of shares of Tata Steel and a few of ITC or some shares of Ranbaxy. He cannot invest in Infosys or HDFC at all. In fact, he cannot invest in more than one or two companies.
He read in an investment journal that the key to good investing is healthy diversification. Buying into just one or two companies goes against that theory. He is in a fix.

At a practice match, Sachin meets Rahul, Yuvraj, Anil and Irfan. Each of them is in a similar situation. Rahul has Rs 1,000 to invest, Anil Rs 800 and Yuvi and Irfan have Rs 500 each. Together, they have a total of Rs 3,800.

They decide to form a mutual fund. They pool in their money and buy one share each of the above 5 companies. They form 380 units of Rs 10 each totalling to Rs 3,800. This Rs 10 is the starting NAV or Net Asset Value. Each person gets the number of units proportionate to their investment. So, here is how their units pan out:

Sachin 100 units (Rs 1000 divided by Rs 10)
Rahul 100 units (Rs 1000 divided by Rs 10)
Anil 80 units (Rs 800 divided by Rs 10)
Yuvraj 50 units (Rs 500 divided by Rs 10)
Irfan 50 units (Rs 500 divided by Rs 10)

After one month, they check out ET again to see what the value of their investments are. Here is what they see:

Tata Steel Rs 450
Infosys Rs 2050
ITC Rs 150
Ranbaxy Rs 280
HDFC Rs 990

Total fund value is Rs 3,920. Total number of units is 380. So NAV is Rs 10.32 (Rs 3,920 divided by 380). So each unit has made a gain of Rs. 0.32 paise. This gain mulitiplied by the number of units held by each person is the gain of each person. So here is the situation of investmtent values of all 5 after one month:

Sachin Rs 1,032 (Rs 10.32 multiplied by 100 units)
Rahul Rs 1,032 (Rs 10.32 multiplied by 100 units)
Anil Rs 825.6 (Rs 10.32 multiplied by 80 units)
Yuvraj Rs 516 (Rs 10.32 multiplied by 50 units)
Irfan Rs 516 (Rs 10.32 multiplied by 50 units)

So, if any of them decides to sell the units, he will make a profit of Rs 0.32 on each unit that he holds. If someone sells and exits the fund, the NAV of the fund will remain unchanged because the number of units will also fall proportionately. Now what I have explained is an optimistic scenario. If the fund value falls below the initial investment of Rs 3,800, the NAVs will be less than Rs 10 and hence each person will bear a loss.

This is the basic of how a Mutual fund works. Now instead of just 5 investors, imagine hundreds and thousands of them.

So what is the moral of the story? How do MFs help?
1) A MF will help you to diversify. Sachin could not invest in all companies alone but could do it mutually with 5 others and share the resultant gains.
2) Diversification in turn, reduces risks. For instance, though the share prices of Ranbaxy and HDFC fell, the value of overall portfolio went up thanks to the rise in price of the other companies.
3) Sachin is a cricket player. So are the others. They have no sense of the market. They need an expert to manage their fund, to decide which stocks to invest in, which stocks within the portfolio to sell or buy and so on. A MF gives you expertise. Of course for a charge.

Coming up:
A look at how do MFs make their money. Its simple - they charge you.

Disclaimer: All these share prices have been randomly assumed. They do not indicate actual performances or quality of stocks.


  • Wow!!! A Big round of applause to you!!
    A great enlightment :)
    if i am looking at a long term investment in stocks, day for a period of 5 years or more in an economy like India, it is highly probable that i make profits, if not huge ;)
    Does this hold good for mutual funds too?
    Because of the risk-reduction factor of involving too many stocks does it make sense to keep MFs for long term??

    By Blogger Suudhan Rangarajan, at 1:01 AM  

  • Hi suudhan,
    You can check out this earlier blog of mine for some gyaan on whether MFs are risky...

    By Blogger Money Gardener, at 2:33 AM  

  • thanks Money Garderner!
    I had missed this post earlier!!!

    By Blogger Suudhan Rangarajan, at 5:45 AM  

  • Good one. Some how we hav to spread ur blog to many so that ppl will read it and get benefits out of this.

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