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