Equity Funds vs Debt Funds: Which Mutual Fund Is Best for You?

When starting into investing, a fundamental decision one has to make is which asset class to put down money in. Between mutual funds, equity funds and debt funds are the two main pillars of portfolio construction. Understanding the differences (risk profile, return potentials) of the two to be built and investing for long-term wealth creation is essential for earning money and long-term future (equity funds are for long-term, high return portfolio investment and debt funds are for capital preservation and long-term income generation).

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Equity funds primarily invest in stocks or shares of companies with different market capitalizations - from small-cap disruptors to large-cap corporate giants. By purchasing units of an equity fund, an investor becomes a fractional owner of these businesses and is in fact a part of the corporate growth and profitability of the country directly. Because the stock market is volatile and macroeconomic swings can happen very quickly, equity funds are more susceptible to risks in the short term. But history shows that equities do rise and fall more quickly than inflation for long periods of time (usually five to seven years or more). And equity funds are the best vehicles for long-term financial goals such as retirement planning, buying a home, and funding higher education, where compounding growth is the best way to keep your money in the bank, even on a market rollercoaster.

Debt funds, on the other hand, are based on fixed-income assets -- government bonds, corporate debentures, treasury bills, commercial paper, etc. When you invest in a debt fund, you are essentially lending the government or high-rated corporations' money in the form of regular interest payments and the return of the principal amount at maturity. Debt funds are much less volatile than equity funds as these are fixed or predetermined returns and therefore are much less volatile. Debt funds are a safe investment for investors looking to protect their principal investments and earn a steady stream of income. Debt funds are therefore best suited to finance short-term goals, emergency funds, or conservative investors with a low risk tolerance and the gut-wrenching drawdowns of the stock market.

Equity funds versus debt funds is ultimately about the personal money needs and the time horizon, and risk tolerance and psychological skill to manage risks; financial professionals don’t suggest putting them in the same portfolio every time and don’t suggest that you either should decide to do one or the other. Younger investors who have decades ahead of them can allocate more of their funds to equity funds in order to get more out of them and then shift to debt funds as they grow older and get ready for retirement to keep their wealth. Investors are able to balance the fast growth of equity funds and the slow growth of debt funds well with that of equity funds and then in the end they will be able to survive the challenges of the financial markets and have a solid well-rounded portfolio.