What are Mutual Funds?

When I was young, my grandmother was a great influencer of my life. Of course still she is! Whenever we plan for a travel she will take the cash and keep some in her wallet some in bag and some in my pocket and some in my mother’s wallet. I asked my grandma why so?

She will say “If you lose one amount by mistake or someone poaches it, the other will help you. Instead, if you keep all in one purse and if you lose the purse you lost the way.”

It was this concept in operations called as buffer, in engineering called as “Safety Factor” and in finance “The Balanced Portfolio“.

This is the underlying principle of mutual funds where instead of investing in one stock, they invest in a portfolio of stocks thereby they can minimize one’s risk and obtain optimum returns.

Let me try to explain this with two simple stocks for example. Let us consider one stock whose share value increases when index (assume sensex) increases and another stock whose share value decreases as sensex increases. The first one is called as “Positive Correlation” and the second one is called as “Negative Correlation“. The value which we use to measure how much the stock price increases with respect to sensex is called as “Beta“. It is nothing but the slope of the curve drawn in a graph where we take “sensex” (index) value in x-axis over a period of time and stock price in y-axis. So the first stock will have a positive beta value and the second one a negative beta value.

Now assume if you invest in only first stock assuming that sensex will move up and if it goes down you are going to lose a lot. Similarly if you invest in second stock thinking that sensex will go down and if it increases you will once again lose. Incase, if you invest in both the stocks (in proportion to how much their price vary according to the sensex index) you may not get maximum return but whatever be the sensex(index) movement bullish(upward) or bearish(downward) you will get optimum return. This is how mutual funds choose their stocks in their portfolio and maximize their returns and minimizes their risk.

But choosing stocks is not that easy as we mentioned. Many things in life are written but done with sweat. This is not an exemption for that. Based on this principle, some funds choose stock pertaining to only one sector called “sector funds“. Some in proportionate amount listed in all sectors in an index called “index funds” and so on.

This is simple thing we can also do as an investor by tracking the stock price. Instead of investing one stock, pick two or three by logics (or use tools if you can) and we can minimize risk.

And hope a few who benefit out of this will always be thankful to my great investment guru “my grandmother”.