Debt or Equity Funds – How Do You Make the Choice?

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On deciding that it was time to take his future in his own hands, Adam Lin set up a mutual fund SIP with a recurring deposit of $500. He pooled his funds in the debt market and though he enjoyed not having to face high risk, he was dismayed when he compared his fund at maturity with a friend’s earnings, which were exponentially higher.

Adam’s goals of paying the down payment for his parent’s home was one that he had to put off for another few years. Though the act of investment itself was a positive experience for him, his returns did not satisfy him the way he had hoped.

When investing in funds, many novice investors make the mistake of picking funds based on their promised rate of interest, and then call it a day.

They do not delve into the deeper details of the funds, such as how much of their money is invested in debt and equity markets, and therefore, do not see the kind of growth they had forecasted when they used a calculator online. Before you begin investing in a specific scheme, understand whether you should pool your money in equity or debt funds.

What is the difference between debt and equity?

Debt funds are those which invest in the debt market and instruments that yield a fixed and specific income. These mutual funds are considered to be low-risk ones and are ideal for investors who cannot bear rapid fluctuations in the market. Government bonds are an example of such funds. Contrary to popular belief, debt funds also grow well. However, comparing their growth with the growth of equity funds is like comparing apples and oranges – the two markets function quite differently.

Equity funds are asset classes that belong to the equities market. These are used for long-term financial growth and offer high returns on investments that are known to beat inflation. Such funds invest in high-risk avenues such as the stocks of a known company. In order to truly gain from such investments, investors need to pick a term period of a minimum of 7 years. But do not let that dissuade you.
In terms of the life cycles of most investments, seasoned investors find themselves pooling their money for up to 40 years. Of course, something as small as the duration of the term should not be the final nail in the coffin when you’re picking your funds.

How can you choose between debt and equity funds?

When choosing between debt and equity funds, you must take into account a variety of factors. Once you have analysed the following to the best of your ability, you can start picking out specific mutual funds to invest your money in:

Returns on investment (ROI)

Often, identifying the kinds of returns you expect from your investment is a good place to start. Let’s say that your main goal is to buy a car worth $105,000 within a set time period. At this point, you know that you want your funds to grow till this amount (or higher). You’ve also identified the term period within which you want to achieve this goal. Now, comes the choice between debt and equity. Based on the premiums that you’ve set for yourself, you can calculate an average rate of returns from debt markets to be around 9% and the average for equities to be around 16%. Of course, these are only ballpark figures! However, this should give you an indication of the fund’s performance and help you choose which assets to invest in.

The risks involved

Your risk appetite refers to how much market fluctuation you are willing to withstand. If you cannot handle fluctuations and need guaranteed performance, then the debt market is right for you. Conversely, if you want high ROIs and do not mind the risk that comes with it, then you should pick equities. Think of it this way, your choice is between a certain growth of 9% vs. an uncertain growth of 16% (again, these are ballpark figures – the rate of interests differ with various schemes).

Duration of the term

Another way to identify whether you should invest in the debt or equities market is to identify how soon you want your funds in your account. If you are looking at steady growth within a short span of time like 5 years, then the debt market is more suited to your needs. Similarly, if you are willing to invest your funds for 10 or 20 years (or even longer), then the equities market can suit you more. Of course, if you have a low risk appetite, you can still pick the debt market even with a higher term period.

Income generation vs. wealth creation

The main goal behind your investment can also help you choose the assets that you should invest in. If you prioritise income generation, then debt funds are ideal as they come with guaranteed returns. However, if you want to grow your wealth exponentially, then equities funds are the ones that are right for you.
Now, these are a lot of different factors and you may find yourself feeling a little flummoxed while identifying them all. The trick is to know which of these factors is the most important to you and then base your decision with that in mind. For instance, if you value security and stability above all else, then go right ahead and invest in debt funds.

Diversification – the balance between Equity and Debt!

At this point, you’re probably wishing that you could have the best of both worlds. Don’t you wish there was a way to enjoy high ROIs along with the security that comes with debt funds? The answer to this dilemma lies in balancing your portfolio. By diversifying your funds in both the debt and equity markets, you can ensure that a certain amount of money sees the high growth promised by equity funds, while the rest of it also grows nicely, albeit in a stable and safe way.

In order to invest in both markets at the same time, you must choose a term period of over 5 years. This is because equity funds are the most beneficial will coupled with longer terms.7 years can be the ideal period if you want to enjoy your earnings quickly. If not, you can always invest for a long term goal by setting your term period to be 10 or 20 years.

Striking this balance between the two funds can be the best way to invest in mutual funds, especially if you are a novice and want the funds to do all the work for you! Seasoned investors, on the other hand, switch from debt to equity funds by analysing the market to prevent high risks.