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Short-Term Vs. Long-Term Mutual Funds: Investment Options Simplified

Posted on 25-Jun-2024

6 min read

The perennial debate of long-term vs. short-term investments in mutual funds often perplexes investors. Which is the best option? Find out in this blog post by Shriram AMC.

Table of Content

One of the most important factors investors need to focus on while choosing mutual funds to invest in is the investment horizon. Of course, this might feel like a no-brainer if you are already a seasoned investor. But if you are still pretty new to investments, always remember that choosing funds based on their tenure should be one of your priorities. 

While trying to figure out the best mutual funds for you, a debate you’ll often find yourself in the middle of is this: long-term vs. short-term investment. Fret not’ we have got you covered!

From understanding the importance of investment horizons to navigating the nuances of short-term and long-term investments, we’ll cut through the jargon, simplifying your investment options.

Let’s begin.

Key Differences Between Long-Term and Short-Term Mutual Fund Investments

The primary distinction between long and short-term investments lies in the investment tenure. Short-term mutual funds aim for returns within a few months to a couple of years. These funds invest in relatively stable instruments like money market securities or short-term bonds. Conversely, long-term mutual funds have a time horizon of several years or even decades. They primarily invest in equities (stocks) or assets with the potential for high growth over extended periods.

Here’s a tabular comparison between the two to help you gain more insight:
 
Parameters Long-Term Mutual Funds Short-Term Mutual Funds
Interest Rate More sensitive to interest rate movements Less sensitive to interest rate movements
Returns Higher potential returns Lower potential returns
Risk Higher Lower
Goals Wealth-creation, retirement corpus, long-term financial planning Short-term financial needs like travel, down payment, emergency fund, etc.
Duration Several years (at least 5+) or decades Couple of months to a couple of years

How Long Should You Remain Invested in Mutual Funds?

There isn’t a one-size-fits-all answer to this question. Mutual fund investments come with nuances that every investor needs to understand, especially when it comes to the investment horizon. 

But we can explain the nuances of the investment objective.

1.    Investment Horizon
The ‘right’ investment horizon really depends up on your investment style, financial goals and risk appetite, to name a few. For instance, if building a decent retirement corpus your primary goal, staying invested for a long term, say more than five years, should be the right duration. 
On the other hand, if travelling to Europe next summer on your bucket list, investing in short-term mutual funds can be just the thing for you.

But hold on! There’s another aspect to deciding on the suitable investment horizon that cannot go amiss. And that’s taxation.

2.    Impact of Taxation
There are typically two types of taxation on mutual funds—tax on Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG).

STCG taxation is applicable when an investor holds units of equity mutual funds for less than a year. LTCG taxation applies when an investor holds the units beyond 12 months. If you want to leverage the tax benefits from LTCG, staying invested for more than 12 months might be a good decision.

Pros and Cons of Long-Term and Short-Term Mutual Funds

We’ve covered the duration of staying invested in long and short-term mutual funds. And now we know how to choose funds based on our risk tolerance, financial goals, and the tax benefits we want to reap. Now we need to discuss another important aspect—advantages and disadvantages of long-term and short-term mutual funds.

Benefits of Long-Term Mutual Funds

Let’s begin with the benefits of long-term mutual funds:

•    Higher growth potential: Equities have historically outperformed other asset classes in the long run.

•    Power of compounding: Reinvesting your earnings leads to exponential growth over time.

•    Favourable tax treatment: Long-term capital gains on equity funds held for over a year attract a lower tax rate compared to short-term gains.

•    Rides out market volatility: Long-term investing allows you to weather market fluctuations and benefit from overall market trends.

Shortcomings of Long-Term Mutual Funds

Here are some of the drawbacks of long-term mutual funds:

•    Higher risk: Equity markets are inherently volatile, and short-term fluctuations can be stressful for some investors.

•    Less liquidity: Long-term funds may have lock-in periods or exit loads, limiting immediate access to your money.

Benefits of Short-Term Mutual Funds

Let us now look at some of the perks of investing in long-term mutual funds:

•    Low risk: Short-term debt funds offer relatively stable returns with minimal volatility.

•    High liquidity: Easy access to your money for short-term needs.

•    Lower tax on gains: Debt funds held for over three years with indexation benefit from lower tax compared to equity funds.

Drawbacks of Short-Term Mutual Funds

Short-term mutual funds come with a few drawbacks too. Let’s look at them:

•    Lower return potential: Compared to long-term equity funds, short-term debt funds offer lower potential returns.

•    May not beat inflation: Over longer periods, inflation can erode the purchasing power of your returns.

More On Long and Short-Term Mutual Funds

Beyond the basic timeframe, a deeper dive into specific fund categories helps tailor your investment strategy. Here's a glimpse into some popular options:

Long-Term Equity Funds

•    Large-Cap Funds:
Invest in stocks of well-established, large companies offering stability and potential for steady growth.

•    Mid-Cap Funds: Focus on stocks of medium-sized companies with higher growth potential but also slightly riskier.

•    Small-Cap Funds: Invest in stocks of smaller companies with the potential for high returns but come with significant risk.

Short-Term Debt Funds

•    Liquid Funds:
Offer high liquidity and near-instant access to your money, making them ideal for emergency funds.

•    Ultra-Short-Term Bond Funds: Invest in bonds maturing within a year, providing slightly higher returns than liquid funds with a touch more volatility.

•    Low-Duration Income Funds: Invest in bonds with maturities ranging from 1 to 3 years, offering a balance between liquidity and slightly higher potential returns compared to ultra-short-term funds.

Remember, this is not an exhaustive list, and many other fund categories exist within both long-term and short-term horizons. Consulting a financial advisor or a reputed fund house, like Shriram AMC, can help you identify the specific funds that align with your risk tolerance and financial goals.

Conclusion

Before we wrap up with our discussion, let’s leave you with a few final parting words. A well-diversified portfolio often combines both short-term and long-term mutual funds to achieve a balance between risk, return, and liquidity. Always consult an investment advisor and take stock of your risk tolerance, investment preferences, and financial goals to decide the suitable portfolio mix for you. 

FAQs

Here are a few questions people ask about long-term and short-term mutual funds:

1.    Can I invest in both short-term and long-term funds?

Absolutely! A balanced portfolio often combines both. Short-term funds can provide liquidity and stability, while long-term funds help build wealth for future goals.

2.    What if my financial goals change over time?

Life is dynamic! Most mutual fund investments allow you to switch between funds within the same fund house (called portfolio rebalancing) to adapt your strategy as your goals evolve.

3.    How much should I invest in each type of fund?

It depends on your risk tolerance, time horizon, and financial goals. A financial advisor can help you determine an asset allocation strategy that works for you.

4.    Are there any tax benefits to consider?

Yes! Long-term capital gains on equity funds held for over a year attract a lower tax rate compared to short-term gains. Debt funds held for over 3 years with indexation also benefit from lower taxes.

5.    What if I don't have a lot of money to invest?

Many mutual funds offer SIP (Systematic Investment Plan) options, allowing you to invest a fixed amount regularly. This is a great way to begin your investment journey and benefit from rupee-cost averaging, even with a small sum.
 

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