Mutual Fund Investment: How Much Of Salary Should You Invest?

Mutual funds are a popular investment option, especially for millennials, due to their flexibility in allowing investors to put in small amounts periodically. However, there is no one-size-fits-all approach to determining the percentage of one's salary to invest in mutual funds. It depends on various factors, including financial goals, income, needs, and risk tolerance. A general guideline is the 50/30/20 rule, where 50% of income covers necessities, 30% is for discretionary spending, and 20% is reserved for savings and investments, with the latter potentially going towards mutual funds.

The 50:30:20 rule

• 50% for needs: This includes essential expenses such as groceries, rent or mortgage, utilities, insurance, and minimum debt payments. These are the costs necessary for your survival and daily life.
• 30% for wants: This includes discretionary spending on things like entertainment, travel, hobbies, dining out, and luxury items. These are expenses that are not essential but improve your quality of life.
• 20% for savings and investments: This portion is meant to build an emergency fund and save for the future. It is recommended to have at least three months' worth of expenses saved for emergencies, with a focus on retirement planning and meeting long-term financial goals.

This rule provides a straightforward framework for budgeting and helps you balance your spending, savings, and investments. It ensures that your essential needs are met while also allowing for some discretionary spending and a focus on financial security.

When investing in mutual funds, it is generally recommended to invest about 20% of your income. This can be further broken down, with 40% of your income going towards investments and 20% of that allocated to mutual funds.

However, the specific percentages may vary depending on individual circumstances, financial goals, and risk tolerance. It is important to assess your financial situation, goals, and comfort with risk when determining how much to invest in mutual funds.

Additionally, the 20/25 rule is a separate guideline for mutual fund investing, suggesting that you invest in no more than 20 mutual funds and limit your investment in any single fund to 25% of your portfolio. This helps diversify your portfolio and reduce risk by avoiding overexposure to a single fund or sector.

Fixed Obligations to Income Ratio (FOIR)

The Fixed Obligations to Income Ratio (FOIR) is a metric used by banks and other financial institutions to assess an individual's loan eligibility. It is calculated by taking into account an individual's fixed monthly expenses, such as rent, utilities, groceries, and any existing loan payments, and dividing this sum by their total income. FOIR can be calculated using the following formula:

> FOIR = (Total fixed expenses) / (Total income) * 100

For example, if an individual has a monthly income of Rs. 50,000 and fixed expenses of Rs. 20,000, their FOIR would be 20,000 / 50,000 * 100, which equals 40%. This means that 40% of their income is allocated to covering their essential expenses, while the remaining 60% is available for discretionary spending, savings, or investments.

FOIR is an important factor in determining loan eligibility because it indicates an individual's disposable income, which is the amount available to repay existing and new debts. A lower FOIR suggests that an individual has a higher repayment capacity and is more likely to be approved for a loan. It also indicates better financial health and the ability to take on additional debt.

When calculating FOIR, it's important to note that statutory deductions from the salary, such as Provident Fund, Professional Tax, and deductions for investments, are typically not included in the calculation. These deductions vary based on income and geographic location.

While there is no one-size-fits-all approach to financial planning, the 50:30:20 rule is often recommended by financial experts. According to this rule, 50% of your income should be allocated to essential needs, 30% to discretionary wants, and at least 20% to building an emergency fund. Once the emergency fund is established, individuals can consider investing this portion of their income in mutual funds or other investment vehicles.

In summary, FOIR is a critical tool used by financial institutions to assess loan eligibility and by individuals to make informed financial decisions. It helps determine an individual's disposable income and their ability to repay debts. By understanding FOIR and incorporating it into their financial planning, individuals can make more informed choices about their spending, savings, and investments.

Emergency funds

It is generally recommended to save at least three to six months' worth of living expenses or necessary expenses as your emergency fund. This amount can vary depending on your personal circumstances, financial obligations, and income. The rule of thumb is that your emergency fund should be enough to cover your basic needs and some discretionary expenses for a short period.

Where Should You Keep Your Emergency Funds?

It is advisable to keep your emergency funds in a liquid or easily accessible account. This could be a regular savings account at a bank or credit union that provides a return on your deposit and allows for withdrawals at any time without penalties. High-yield savings accounts, offered by many online banks, can also be a good option as they typically provide higher interest rates than traditional savings accounts, helping to offset the effects of inflation.

Investing Your Emergency Funds

While keeping your emergency funds in a traditional savings account can provide easy access to your money, you may want to consider investing it to earn higher returns and protect it from inflation. Here are some options for investing your emergency funds:

• Money Market Accounts: These accounts are a mix between checking and savings accounts, usually offering low risk and Annual Percentage Yields (APYs) of around 3-4%. Many money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA) up to $250,000 per account. Some accounts also offer debit card and check-writing privileges.
• High-Yield Savings Accounts: These accounts, often offered by online banks, provide higher interest rates than traditional savings accounts, typically in the range of 3-4% APY. The money in these accounts is usually FDIC-insured, and you can access funds through online transfers, wire transfers, telephone transfers, or check requests. However, online-only accounts may not offer branch access for immediate withdrawals.
• Certificates of Deposit (CDs): CDs offer higher interest rates than regular savings accounts, and they are FDIC-insured for up to $250,000 per account. However, withdrawing money from a CD before it matures typically incurs a penalty. To increase liquidity and avoid early withdrawal penalties, consider creating a CD ladder by purchasing multiple smaller CDs with different maturity dates.
• Money Market Mutual Funds: These investment vehicles, obtained through brokerage and mutual fund companies, invest in low-risk securities such as government securities and certificates of deposits. They are highly liquid compared to other mutual funds, but they are not federally insured and may have expense fees.
• U.S. Treasury Bills: These are backed by the federal government and have very short terms (4, 13, or 26 weeks). They tend to pay more interest than a simple savings account, but you may need to hold them to maturity to avoid losing principal.
• Brokerage (Taxable Investment) Accounts: Investing in stocks through brokerage accounts offers the potential for higher returns but also comes with more volatility. Bonds are generally more stable but may provide lower returns. Index or exchange-traded funds might be a better option than individual stocks or bonds. Keep in mind that you may face transaction fees and taxes on earnings when selling assets and withdrawing funds.

Additional Considerations

When investing your emergency funds, it is crucial to balance risk and return. Investing in volatile assets like stocks may force you to sell at a loss during an emergency. Therefore, it is generally recommended to invest in lower-risk options and maintain a portion of your emergency fund in a highly liquid account that you can access immediately. Additionally, consider increasing the size of your emergency fund to provide a buffer against market corrections.

In conclusion, building and investing your emergency funds is an important step towards financial stability and independence. By following the guidelines above, you can ensure that you have the necessary funds to cover unexpected expenses while also making your money work for you through strategic investments.

Risk tolerance

An investor's risk tolerance is influenced by factors such as age, investment goals, and income. Those with a higher risk tolerance are often referred to as aggressive investors, who are willing to risk losing money in pursuit of potentially better results. Their investments tend to focus on capital appreciation rather than income preservation. This type of investor commonly has a portfolio that includes stocks with little to no allocation to bonds or cash.

On the other hand, conservative investors have a lower risk tolerance and seek investments with guaranteed returns. They are often individuals who are retirees or approaching retirement age and are unwilling to risk losing their principal investment. Conservative investors typically opt for investments that are guaranteed and highly liquid, such as bank certificates of deposit (CDs), money markets, or U.S. Treasuries.

Moderate investors, as the name suggests, take a balanced approach, aiming to grow their money without taking on excessive risk. Their portfolios usually consist of a mixture of stocks and bonds, such as a 50/50 or 60/40 structure.

When it comes to mutual funds, an individual's risk tolerance plays a crucial role in deciding how much of their salary they should invest. Mutual funds offer flexibility, allowing individuals to invest small amounts periodically, making them a popular investment option. While there is no one-size-fits-all rule, financial planning experts typically suggest the 50:30:20 rule as a guideline. According to this rule, 50% of an individual's income should be spent on needs, 30% on wants, and the remaining 20% should be saved for emergencies and building an investment corpus. This 20% can then be further allocated towards mutual fund investments, with the specific amount depending on the individual's risk tolerance and financial goals.

Diversification

When deciding how to allocate your salary towards mutual funds, it's important to understand the concept of diversification and why it matters. Diversification simply means not putting all your eggs in one basket. In the context of mutual funds, it involves investing in a variety of funds with different investment strategies, sectors, and asset types.

• Risk Mitigation: Investing in multiple mutual funds with different focuses helps reduce the risk of losing all your money if a particular sector or asset class performs poorly. By diversifying your portfolio, you're not dependent on the success of a single investment, and you can better manage risk.
• Stability and Long-Term Returns: Diversification can lead to more stable and consistent returns over the long term. By spreading your investments across various sectors and asset classes, you increase the chances of overall positive returns, even if some individual investments don't perform as expected.
• Different Types of Diversification: Diversification can occur at different levels. For example, you can diversify across asset classes by investing in equity funds, debt funds, real estate funds, and more. You can also diversify within asset classes, such as investing in multiple equity funds with different sector focuses (e.g., technology, healthcare, energy). Additionally, you can diversify geographically by investing in funds that focus on different regions or countries.
• Regular Portfolio Review: Diversification isn't a one-time activity. It's important to regularly monitor and rebalance your portfolio to ensure it aligns with your investment goals and risk tolerance. Market conditions and economic trends can change, so staying proactive and adjusting your portfolio accordingly is essential.
• Professional Guidance: If you're new to investing, consider seeking advice from a financial advisor or a mutual fund advisor. They can help you understand your risk tolerance, investment goals, and create a diversified portfolio that matches your profile.

Remember, diversification is a strategy to manage risk and improve long-term returns. It doesn't guarantee profits or eliminate the possibility of losses, but it can help smooth out the ups and downs of the market and provide a more stable investment journey.

When deciding how much of your salary to invest in mutual funds, keep in mind that diversification is a critical component of a well-rounded investment strategy. Diversification can help protect your finances and improve your overall investment experience.

Frequently asked questions