When Do You Need The Money?
If the India growth story holds, then the long term equity investments should be positive. There is substantial evidence that equity investments held for a long time give good returns and are used to beat inflation. What is the reason then that you should invest in debt mutual funds?
Equity investments could be volatile in the short term. If you are a short term investor, then you may not want to risk that the markets are down at the time you need the money. Since debt mutual funds are less volatile, you should invest in debt mutual funds.
What if you’re a longer term investor having consistently invested for more than 5 years in equity funds? During a stock market downturn some of your investments may be down but the older ones may be at a profit. If you don’t need cash at that stage, it should matter less to you.
For A Long Term Investor Then, Do Debt Mutual Funds Make Sense?
Given that one should provide for any eventuality, we believe that everyone should invest some amount in debt mutual funds. How much, would depend upon your risk appetite. Even for an extremely high risk appetite, one should have about 10% – 15% of the investment in debt, to access in an emergency. This is despite the fact that older profitable equity investments can also be accessed.
Building A Foundation For Longer Term Investments
The logic for this is safety first. When you start to build your investment, you should invest some of it in debt as you may need the cash in the short term. As you invest more, this provides a good foundation for longer term investments. You don’t disturb these and allow it to grow with the power of compounding. (Also see: The Power of Compounding). Such longer term investments can be in equity. These may be volatile in the short term but provide good returns over the long term. Any money you require in the meantime can be accessed from debt mutual funds. Also it may be possible that you may require the money when the stock market is down. No point selling equity at that time; rather encase closed-end fund.
Take a look at the following chart which shows 1 year rolling returns over a three year period, when the pandemic related lockdown hit:
(source: Morning Star Rolling Returns)
When the markets fell, any mutual fund that had more than 65% in Equity, had negative returns. However, debt mutual funds had a positive return. Hence debt mutual funds are a good hedge against market falls. Take a look also at how the equity funds rebounded. Had you sold when the markets were down, you would have lost out on the upside.
Eventually you should maintain a debt:equity ratio based on your age and your ability and willingness to take risks.
So, In Summary…
As you start to invest, go for debt investment. Then higher in equity through your major earning years. Continue to invest some in debt for upcoming major expenses (such as marriage, kids education etc). Then again higher in debt as you retire.
You can build your financial plan through Propel Money to guide you on the investment allocation across different products – where, how much and why.