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Risks, Returns, and More – What to Consider While investing in Liquid Funds?

Many people only know of investing as the process of allocating money with an expectation to generate profit. Some also think of it as an act of committing an amount into an investment scheme which they can’t get back before a few years of the lock-in period. Although this is true for some financial instruments like PPF, NPS, and others, liquid funds are different. These are debt funds that invest particularly in short-term instruments like treasury bills, that generate fixed interest and has a maturity period of 91 days.

Investing in one of the best liquid funds ensures higher liquidity and safety for the invested capital, which makes it an excellent option to park your capital surplus. Before you begin investing in these funds, you must know about some crucial things.

1. Consider Fluctuations in Net Asset Value (NAV)

Depending on which liquid fund you choose to invest in, fund managers will invest your capital in allocated proportions defined in the fund’s objective. The allocation makes returns from the best liquid funds less sensitive to changes in interest rates. Fund value does not generally fluctuate significantly over the maturity period. However, you must know that even liquid funds are not entirely risk-free.

The risk related to liquid funds is based on onNAV, which does not fluctuate too frequently. In case the credit rating of the underlying security downgrades, it might fluctuate the fund NAV. This, in turn, will affect the fund returns. Thus, it is crucial to consult financial advisors before you invest in the best liquid funds.

2. Think About Your Financial Goals

This is important to help you set the right expectations while investing in the best liquid funds. As per the basic rule of investing, high returns are mostly associated with high-risk financial instruments. Since there is a low risk associated with liquid funds, the returns are also lower as compared to equities and other instruments. It implies that liquid funds are not meant for wealth creation, but to gain a modest return over your investment.

If your financial goal is to create wealth over the long term, consider maintaining a diverse investment portfolio that also includes high-risk avenues of capital investing. Ask financial advisors like FinEdge about creating such a portfolio for you.

3. Analyze Your Investment Horizon

The fundamentals of investing say that your investment decisions should help manage financial liabilities instead of adding to them. The duration for which you can keep the money invested in various financial instruments may be different from others. Even the best liquid funds are meant to invest money for a short period of up to three months.

A good way to think of liquid fund investments is to create an emergency fund. In addition to good returns, you can take out your money whenever an emergency strikes. If you have enough capital along with a longer investment horizon of up to one year or more, consider investing through other short-term mutual funds that give comparatively higher returns.

4. Know About the Tax Payable on Gains

Taxation is yet another aspect of investing in the best liquid funds. The capital gains you receive with your debt fund investments are taxable at the rate depending on the holding period. The returns you gain in the first three years of investment fall under Short Term Capital Gains (STCG). With liquid fund investments, the STCG will be added to your income and taxed as per the income tax slabs. It is different from Long Term Capital Gains (LTCG) which are taxable at 20% rate post indexation. If you are new to investing, it is crucial to consider taxation while investing in liquid funds.

Liquid fund investments can prove useful, provided you know how to invest right. While selecting a fund, make sure you analyze it from various perspectives before making any final investment decision.

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