With markets at an all time high, retail investors are rushing towards equity markets/mutual funds with their hard earned money. Hence, we thought it apt to discuss some of the common pitfalls investors should avoid while selecting mutual funds.
Pitfall 1- Lower NAV is better
Fund A has an NAV of Rs. 45 while Fund B has an NAV of Rs. 225. Assuming all the other parameters are same, which fund will you pick? Most retail investors feel that the fund with a lower NAV is better. In fact, during the last bull run, most mutual fund houses launched a number of new fund offers to attract investors. Since the new fund offers are generally made at a price of Rs 10, the demand for such offers was also high as the units were available at a low NAV. If you feel the same way, you could not be further away from the truth.
Let’s consider an example. Suppose you purchase 1000 units of Fund A at an NAV of Rs. 45, you total investment in Fund A is Rs. 45,000. On the other hand, if you purchase 200 units of Fund B at a NAV of Rs. 225, you investment in Fund B is also Rs. 45,000. If both the funds return 10% in the next year, NAV of Fund A would have grown to Rs. 49.5, while NAV of Fund B would have grown to Rs. 247.5. However, your investment in both the funds would have grown to same amount of Rs. 49,500 in both the funds. Hence, NAV of the mutual fund simply does not matter. There are several parameters that you must consider while selecting mutual funds for your portfolio but NAV isn’t one of them. Infact, one can argue that the older funds with higher NAV are probably better to invest in, because they may have a more experienced fund management team.
We have covered the parameters to look out for while selecting mutual funds in a different article here.
Pitfall 2- Lack of investment discipline
Retail investors flock to the markets when markets are making newer highs. Subsequently, when the markets crash and start hitting fresh lows, investors grow frustrated with their losses and exit their investments. When the next upcycle comes around, they wait on the sidelines with losses of the last down cycle still fresh in their minds. Again when the markets are making newer highs, greed takes over and feeling left out, they start investing in the markets, and then sell again when the market crashes incurring losses. And the cycle goes on.
No one can deny that equity mutual funds are inherently volatile products but there is no point trying to time the markets. So, to take care of this behavioural problem, investors should make regular investments in the mutual funds regardless of the market levels. This can be done by setting up a systematic investment plan (SIP). Investment through SIPs takes care of the behavioural problem, brings discipline to investing and provides benefit of rupee cost averaging.
Pitfall 3- Pseudo diversification:
Mr. Sharma has a mutual fund portfolio of 10 lacs). He has invested Rs. 2 lacs each in banking funds (mutual funds which invest in stocks of banks and other financial institutions) of five different fund houses. Would you call this diversification? What if he has invested Rs. 2 lacs each in five different mid cap funds? Even the best performing mutual funds cannot provide the diversification if the asset allocation is incorrect. We must understand that mutual funds so not perform in isolation and hence are not immune to industrial and economic cycles. Stocking up of similar assets in your portfolio can give you a rude shock when the cycle turns unfavourable.
If your asset allocation is correct, there are valuable resources such ValueResearch and MorningStar available on the internet to help you decide the right mutual fund for you. But first you must get your asset allocation right. Your asset allocation depends on ability to take risk and the willingness to take risk. Parameters such as your age, qualification, income, current assets and liabilities, marital status, number of dependents, need for liquidity etc play an important role in deciding the right asset allocation for you. You can avail services of a financial planner/advisor to assess your risk profile and get the right asset allocation for your profile. The returns of different asset classes are not perfectly correlated (different asset classes perform differently at various points of an economic cycle). Thus, not only does the proper asset allocation help you achieve true diversification but also helps you earn better risk adjusted returns.
For example, your financial advisor might recommend the following asset allocation based on your risk profile and investment preferences.
Real estate: 40%, Debt: 10%, Gold: 5% and equity 45%
Within equity allocation, he might recommend (45% allocation to large cap funds, 30% to multi cap funds, 20% to midcap and small cap funds and remaining 5% to sector funds). Please note one can take exposure to debt and gold through mutual funds too. Investors achieve proper diversification by diversifying at two levels, first at the time of asset allocation and second within that asset class.
Pitfall 4- Too much attention to short term performance:
As highlighted above, different asset classes offer different results at various stages of an economic cycle. Additionally, within an asset class, say equities, stocks from different sectors (technology, pharma, banking, FMCG, agriculture etc) and types (large cap/ midcap /small cap) may perform better than the others. So, a fund which had higher exposure to technology stocks at a time when technology stocks outperformed is likely to perform better than other funds. The credit for this outperformance should go to the fund manager for using an effective strategy. However, this could also be due to fund manager’s preference/bias towards technology stocks or sheer good fortune. If this is the case, the fund performance shall suffer when the technology stocks underperform. Too much attention to short term performance can also make you build an unduly large exposure to sector funds.
To overcome such problems, we recommend looking at 3 year, 5 year and 10 year returns, if available for diversified funds to compare fund performance and make an investment decision. This would reduce effect on fund performance due to fund manager’s biases/preferences or one-time fortunate decisions.
Pitfall 5- Invest to save taxes
Investments up to a maximum of Rs. 1,50,000 in equity linked saving schemes are exempt under section 80 C. In fact, ELSS is the shortest lock-in product (3 years) in the basket of investment products allowed for exemption under section 80C. First time investors get an additional benefit under Rajiv Gandhi Equity Savings Schemes (RGESS). This is why retail investors flock to such schemes in the months of February and March to save taxes. Investing lump sum amounts into such funds increases market risk to an extent and does not give you the benefit of rupee cost averaging.
While there is nothing wrong in saving taxes, principles of mutual fund investing do not change just because you have been extended tax benefits by the government. Such funds shall be chosen keeping your entire asset allocation in mind and investors should take exposure to such funds through systematic investment plans.
We have highlighted a few mistakes that mutual fund investors make. This is not a comprehensive list but we can assure you avoiding these aforementioned mistakes can significantly improve your chances of investing success.
Deepesh is Founder, PersonalFinancePlan.in
26 thoughts on “Five mistakes to avoid while investing in mutual funds”
Mr. Deepesh,
Quite late catch up with your articles. All are great, easy to understand and example are awesome.
Let us say myself and my wife wants both wants to start SIP’s. Should we choose same funds or different funds?
Little insight will be very helpful.
Thank you in advance.
Thanks. I am glad you found the articles useful.
You shouldn’t trust all your holdings with the same fund manager.
So, you should diversify across fund managers (and fund houses) too.
To answer your question, you and your wife can invest in different funds but those funds should be good.
You can have 3-5 funds in your portfolio and 3-5 in your wife’s portfolio. 1 or 2 funds can be common and remaining can be different.
Additionally, do not pick up same kind of funds.
Having five large cap funds in the same portfolio makes little sense.
For instance, pick 2 good large cap equity diversified funds, one multi-cap and one mid & small cap fund for your portfolio.
The exercise can be repeated for your wife’s portfolio.
You do not have to go to every fund house. Shortlist 2-3 fund houses (AMCs) and pick up good schemes from those funds houses.
Hope this answers your question. Let me know if you need any clarification.
Hi Deepesh,
Thanks for the very insightful article. One question around the no. of funds in a portfolio. I see generally 3-5 fund per portfolio is suggested.
I have 3 portfolios – retirement, child’s education, child’s marriage… is it better to have 3-5 funds per each portfolio, which means I might around 12 funds overall, although it helps more easily to differentiate which fund is in which portfolio? Or, is it better to have the same funds in each portfolio, which then means around 4 funds overall?
Any advice is much appreciated. Thanks!
Hi Shankar,
It is a personal preference. Some work with only a few funds. Some go for goal based planning and have a few funds for every goal.
As long as you can manage, it should not be a problem.
12 funds is not too high a number. Same fund or different funds for different goals, it is your choice.
Problem is when you have 50 or 60 funds or even more.
Thanks much for your speedy & helpful response, Deepesh. Happy Diwali!
You are welcome, Shankar!!!
Happy Diwali to you and your family too!!!
i am a investor of Rmf from last 4 and half year.i invest 2000rs. per month in reliance equity opportunity fund regular plan growth option.i want to know should i switch from regular plan to a direct plan.if yes how i can do same as i am a offline investor.but would my tax liablity on long term gain.will i charge any exit load or not.
You can visit the nearest MF office and fill a form to switch from regular plan to direct plan. Switch is considered redemption from regular plan and a fresh investment in direct plan. Hence, capital gains tax and exit load implications may arise.
If you sell the MF units after 1 year, the resulting gains qualify as long term capital gains. Long term capital gains on equity funds are exempt from tax. For equity funds, exit load is typically charged if you redeem your units before one year.
Please understand every installment of a SIP is considered fresh investment. Hence, for purposes of capital gains and exit load implications, every installment is a different investment. Considering you have been investing for the last 4 years, units purchased in the last twelve months will be subject to exit load. Moreover, any short term gains w.r.t to such units will be subject to tax at 15%.
What you can do: Cancel SIP in regular plan and start SIP in direct plan. Switch only those units which you bought more than 12 months. You can switch the units you bought in the last twelve months after some time. This way, there will be no tax or exit load implications.
So far I’ve never invested in MF or stocks, but your articles motivated me to make some investment in MF. Thank you!
I was doing some research on MF returns and one thing I don’t understand. Most of the funds provide good returns for time range of 2-3 years but for long term it’s comparatively low.
(Reference from money control – Mostly the pattern follows as below)
Return for 1,2,3,5,10 years are 10%,25%,35%,18%,12% respectively.
This is little confusing.Is it like then we should invest in MF for 2-3 years to get good returns which is like >30% rather than for 10 years which is expected to produce around 12-15%.
Am I mis calculating anything here? Is it like those funds are not doing well in long term – could you help me to understand ?
Hi Sundhar,
Am glad you have found the posts useful.
With mutual fund investments, you should focus on long term returns.
12% compounded over 10 years is excellent.
I understand your point. At the moment, 2 and 3 year returns will appear high. The reason is these are point to point returns. For instance, 2-year return is from January 13, 2014 to January 13, 2016. So, if the markets were subdued in January 2014, you will get high values for 2-year returns.
On the other hand, if you had elevated levels in Jan 2014, the 2-year return will be low now.
It is not that mutual funds returns 35% per cent every two years.
It is not easy to generate 35% compounded returns over long term.You can do it in the short term if you happen to get on the right side of the cycle.
If the markets do not move anywhere in the next 4-5 months, you will see 2 year returns decline substantially.
That’s why for better performance assessment, you must focus on SIP (XIRR) or rolling returns.
Please go through the following post.
http://www.personalfinanceplan.in/mutual-funds/focus-on-sip-returns/
Very nice and precise article, easy to understand.
Thanks Gopi. Appreciate your kind words.
Please do share with friends and family.
This was a great Post Deepesh. I really like the “Pitfall 4- Too much attention to short term performance”. In fact, this is perhaps the main reason that most investors get jittery and get out of the funds with a hope to find greener areas. The Sensex and Nifty Analyis has shown that over long term holding over 5 years, the chance of negetive return is less than 10% and on possibility of return over 10% CAGR is as much as 70% irrespective of the choice of years.Patience is the KEY.
Thanks Varadarajan. Glad that you liked the post.
Please do share with friends and family.
Yes, this is one of the major reasons why investors can’t stick to investment discipline.
As they say, grass is always greener on other side 🙂
Hats off… May God bless you..
Thanks for helping us with the invaluable ideas…
Thanks Neelam for the kind words. Glad you found the post useful.
Please do share with friends and family so that they can also benefit.
Hey Deepesh. I am new to mutual funds market. I have just started investing through funds India. But they don’t provide direct plans. And I am in urgent need of a financial advisor. Please tell me how and when can I contact you for the same. I want to invest in stocks as well. Please guide me and do reply a.s.a.p
Dear Nandini,
Please understand I provide investment advice only on professional basis.
Please visit the offerings section for more details.
http://www.personalfinanceplan.in/our-offerings/
Thank you for the excellent article.
I have come to understand that for “Debt funds (Dividend reinvestment option) each dividend is taxed automatically at the time of reinvestment. Please explain tax liability for such funds at the time of exit or switch out.
Under dividend reinvestment option, your funds get reinvested at the NAV on the day of dividend reinvestment.
Subsequently, you will have to pay tax if there is any capital gains tax liability at the time of redemption.
You purchase 10 units at 100. NAV grows to 110. Dividend of Rs 7 is announced. Total dividend of Rs Rs 70.
DDT is deducted. Remaining amount is invested at applicable NAV (Rs 103).
So, you have 10 units at 100 and a few units at 103.
At the time of redemption, these values will be considered for calculation of capital gains tax liability.
Hi
I am Harsha and have started getting around Mutual Funds and different Investment plan.
I habe NRO and NRE ac.
Would it be better for me to invest in repatriable NRE ac
Or non repatriable NRO ac
I have an account with Bank of Baroda so how their mutual funds work. Or how i buy when I am totally new but want to learn as your website helping me to understand basics
Regards
Harsha
Hi Harsha,
NRE looks like a better choice. You can easily repatriate too.
If you are a new investor and have these basic doubt, Will suggest you work with SEBI Registered Investment Adviser or a MF distirbutor.
Hi there
Finding to learn my basics on your website easy. My first time to enter in finance market so have lot to learn from your posts
Thanks Harsha!!!
Please share the blog posts you like with your friends too.
Only for Long Term Investment: Just a proposal. Lets discuss
Direct investment in Stocks can be so simple vs invest in MF.
Read this strategy:
Look for successful MFs by credible fund managers, look at the portfolio, note down all those stocks and percentage of allocation.
Now, consider you investment value and mimic the MF portfolio, thats it. Watch the Portfolio on every month, shuffle the stocks based on increase or decrease in percentage of allocation. I agree the profit earned is tax liable but the profit earned from direct stocks will be huge compare to returns from MF investment.
Sunil,
Not sure if I got your question right.
You can’t beat a portfolio by copying it.
Perhaps, you want to avoid fund management costs.
However, transaction costs, taxes and tracking error will eat into the returns.
I have not even considered the numerous behavioural issues with this approach. For instance, how do you know which fund manager is right? Fund Manager has bought Stock X while Fund manager B has sold it. Now, the choice requires decision-making and can create much confusion.
Don’t think its worth the pain.
If you can do research and figure out good stocks on own,