What is the best investment option for conservative investors?

Conservative investor can invest in debt mutual funds as they offer the benefit of stable returns as well as diversification.

In India, various investment options are available where an investor can park his money and fulfil his financial goals and commitments.

Every individual has a different risk appetite and different investment horizons. An individual with a higher risk appetite can invest in equity directly or equity-oriented funds, individuals having moderate risk appetite can invest in hybrid funds or can invest directly in equity or debt instruments in proportion and lastly, conservative investors who have a low-risk appetite, can invest in debt funds or can invest directly in debt instruments.

Looking at this requirement mutual funds offer various types of schemes to investors under categories such as equity funds, debt funds, and hybrid funds.

In this article, we will focus on debt funds schemes.

Debt funds are fixed-income funds that are less volatile than equity funds. These funds invest in debt instruments like commercial papers, government securities, treasury bills, corporate bonds, and other money market instruments. The debt issuer pre-decides the interest as well as the maturity period. Investors with a lower risk capacity choose to invest in these types of funds. Ideally, the portfolio of every investor should consist of some proportion of debt for the stability of the portfolio. Out of all investment options available for conservative investors, debt funds are best as they offer diversity.

What should investors know before investing in these funds?

Risk: Debt funds are riskier than any other fixed deposits as these funds consist of interest rate risk as well as credit risk. Fluctuations of interest rates cause changes in the value of the fund. The interest rate and value of debt funds (NAV) have an inverse relationship. Likewise, credit risk means the risk of default.

Returns: Debt funds offer higher returns than fixed deposits but lower returns than equity. The net asset value (NAV) of the fund fluctuates with the change in interest rates. When the interest rate increases, the NAV of the fund falls whereas, when the interest rate falls, the NAV of the fund rises. Therefore, they are suitable in the falling interest rate phase.

Expense ratio: The asset management companies charge fees for managing the fund and this fee is known as the expense ratio. The expense ratio is the percentage of the fund's total assets. It affects the returns of the fund.

Investment horizon: Debt funds offer terms such as -

Short-term investment horizon: Investors, who wish to invest for a shorter period such as 3-month to 12-month, should opt for liquid funds that allow investing for a shorter time horizon. The typical tenure for the short term is 2-3 years.

Medium-term investment horizon: Investors, who are ready to invest their money for 3-5 years, can invest in dynamic bond funds, which offer quite a high return than fixed deposits with the same lock-in period.

Therefore, the longer the investment horizon, the greater is the returns. 

Taxation: Any capital gains arising on these funds vary depending upon the holding term of the investment. If any capital gains arising are less than three years, then it will be short-term capital gain, which will be taxed as per Income Tax slabs. If capital gains arising are more than three years, then it will be long-term capital gain, which will be taxed at the rate of 20%.