How Much Salary Should You Invest in Mutual Funds?

Over the last decade and a half, mutual funds have become a preferred option for Indians looking to invest in the stock market. Mutual funds give a know-nothing investor an easy way of investing in the stock market without having to choose individual stocks.

By putting their money in a mutual fund, be it an actively managed scheme or an index fund, retail investors can spare themselves the hassle of picking and managing stocks, something they may have little or no expertise in.

Moreover, with digital platforms mushrooming and direct mutual funds becoming mainstream, people are taking to an option that allows them the flexibility to invest small amounts frequently and gain from a robust stock market that has been rising over the past several years.

Ways to decide how much to invest in mutual funds

So, if you are getting a steady pay cheque, how much of your salary should you invest via the mutual fund route?

While there is no hard and fast rule on how much money should be invested via the mutual fund route, you should consider a few things before deciding on the investment amount.

Determine your goals

As a first step, salaried people should set a financial goal for themselves that takes into account not only their own ambitions but also the situation of their family and any dependents that they may have to look after now or later.

A goal-based investing strategy is the most effective way of investing for the future.

Financial goals can vary quite a bit—from buying a new phone or a car to taking a vacation, to much bigger ones like marriage, a kid’s education, healthcare and retirement planning. Any future milestone can become a financial goal, for which one can begin investing via the mutual fund route.

The 50-30-20 formula

The amount one puts in mutual funds, the frequency of investments and the holding period can vary from person to person. Financial planning experts typically suggest a simple rule of thumb that can guide investors who know little about investing and are just getting started on their investment journey.

Experts say that a salaried person, or even one making a living from a business, should typically spend half of his or her income on personal needs, 30% on wants and 20% should be put away in an emergency fund.

To be sure, this is just an indicative rule and each person should tailor it according to their needs, aspirations and situation. There is no one-size-fits all approach that can be suggested to everyone.

‘Needs’ are typically those expenses that simply cannot be avoided. These include basic necessities like food, clothing, housing, travel and medical expenses.

‘Wants’ are discretionary expenses that one undertakes once all the needs have been met. These expenses include money spent on entertainment, travel, luxury goods and services that help improve one’s quality of life.

Beyond needs and wants, financial experts say, a person should maintain an emergency fund, and should apportion at least 20% of one’s income towards maintaining such a kitty. This fund can help a person tide over a tough situation such as loss of employment or an unforeseen medical expense.

Experts say that once a certain minimum amount of money, which could vary from six month’s income to three times one’s annual salary, is collected, then one should begin investing in mutual funds.

FOIR

So, now that we have our basics covered, we need to focus on the actual tasks of investing. For this, one can use the so-called Fixed Obligations to Income Ratio (FOIR) formula.

FOIR helps a person ascertain the amount of money they can invest each month via the systematic investment plan, or SIP, method. Over the last few years, SIPs have become the preferred method by which middle class Indians invest in the stock market via the mutual fund route.

FOIR is calculated using the following formula: (total expenses / total income)*100

So, for a person earning say Rs 1 lakh a month, with fixed expenses of Rs 30,000, the FOIR is 30%. This effectively means he or she has Rs 70,000 a month that can be invested in mutual funds or into any other instruments.

15*15*15 Rule

Financial planners and mutual fund advisors also often talk about the 15*15*15 rule. To be sure, this is not so much as a rule as a general guideline.

This rule basically provides the power of compounding over the long term. As per this rule, mutual fund investors can hope to create a corpus of Rs 1 crore if they invest Rs 15,000 via SIPs per month for 15 years, provided they earn an annualised return of 15%.

Things to consider before investing in mutual funds

Mutual fund investors should keep a few things in mind before they decide to start investing.

Investment duration: In the short term, equity investments tend to be volatile. But over the long term, return from equities typically beats inflation. In fact, among all the asset classes, which include real estate, debt and equities, only equities have successfully beaten inflation over the past few decades across India and most of the developed countries in the world.

Inflation: After taxes, inflation is the next biggest threat to wealth creation as it eats away at one’s accumulated corpus, thereby reducing its purchasing power. So, one should invest a portion of their money in equities to grow their wealth over time

Power of compounding: Mutual funds help an investor compound their money over the long term. So, by investing just small amounts on a monthly basis, a retail investor can generate significant wealth over time.

It is, however, important to start investing as early as possible. For example, if a person begins investing say Rs 1 lakh a year at age 25, in a fund that generates an annual average return of 10%, he will have Rs 2.7 crore when he turns 58. But a person who starts investing at age 35 in the same fund will have less than Rs 1 crore when he turns 58.

Time in the market versus timing the market: What this means is that one should never try and time the market and should continue investing through its ups and downs.

How to invest in mutual funds after deciding how much to invest?

Traditionally, investors relied on distributors to invest in mutual funds. But investing in mutual funds is now easier than ever before, thanks to a plethora of digital investment platforms such as 5paisa.com.

All one needs to do now is sign up with one of these platforms, fill their basic information and complete their know-your-customer requirements.

Once the sign-up process is done, one should do a little bit of research, choose a few schemes and start investing.

Conclusion

Before you begin to invest via mutual funds, it is important to try and follow the 50-30-20 rule. This imparts discipline in you and also helps you create an emergency fund.

Simultaneously, one should determine the money one can put aside for investing, using the FOIR method. This can go a long way in streamlining the investment process.

One should identify the major goals that one is aspiring to achieve both in the medium as well as the long term and invest accordingly.

Most importantly, you should never stop the process of investing as it can impact your compounding significantly over the long term and you can end up with a corpus far lower than you might have otherwise done.