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When you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio.

As dividends and other interest income sources are declared for the fund, it can be used to purchase additional shares in the mutual fund, therefore helping your investment grow.

Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities depending on the focus. Numerous stock index mutual funds own 1,000 or more individual stock positions.

Equity Funds
The most popular types of mutual funds to invest in are Equity funds. The major portion of such shares are dedicated to stocks. Equity funds aim to provide capital growth by investing in the shares of individual companies. Any dividends received by the fund can be reinvested by the fund manager to provide further growth or paid to investors. Both risk and returns are high but equity funds could be a good investment if you have a long-term perspective and can stay invested for at least five years.

Debt or Income Funds
A fixed income mutual fund is concentrated towards investment in funds that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The aim of debt or income funds is to provide you with a steady income. These funds generally invest in securities such as bonds, corporate debentures, government securities (gilts) and money market instruments. Opportunities for capital appreciation are limited.

Balanced Funds
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. The investor may wish to balance his risk between various sectors such as asset size, income or growth. Therefore, the fund is a balance between various attributes desired, however, NAVs of such funds are likely to be less volatile compared to pure equity funds.

Liquid Funds
Liquid funds are a safe place to park your money; it is an appealing alternative to bank deposits because they aim to provide liquidity, capital preservation and slightly higher interest rates than bank accounts. Returns on these funds fluctuate much less compared to other funds as the fund manager invests in ‘cash’ assets such as treasury bills, certificates of deposit and commercial paper.

Index Funds
Another group of funds, which have been extremely popular amongst other types of best performing mutual funds in India are the Index funds are which are passively managed funds i.e. the fund manager attempts to mirror the performance of a benchmark index like the BSE Sensex or the S&P CNX Nifty, by being invested in the same stocks. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index.