Mutual fund investing is simple yet many times investors fail to get all the benefits they deserve because they fall prey to some common mistakes in investing. Read about 4 costly mistakes to avoid while investing in mutual funds.
1. Not knowing what you’ve invested in – Sometimes investors buy mutual funds without any idea of what the underlying security is or what type of fund it is. They invest on the basis of ‘hot tips’ that they receive from their sources. They might argue how it matters at all as long the fund they’ve chosen is giving decent returns. The point however is, these things tend to matter when performance of the fund deviates from what was expected.
Many investors having dozens of mutual funds in their kitty for the sake of ‘diversification’ may surprisingly find they’ve achieved very little diversification if they actually were to glance through the portfolio of their funds. Blame this on ignorance of investors.
Knowing what you’re investing in is critical because that would help you set expectations right and plan for goals effectively. For instance it would tell you that it is irrational to expect your diversified large cap fund to give stellar returns when share markets are in a damp phase, or that equities are to be avoided if your investment horizon is short, no matter how attractive the returns look.
Knowing whether the fund is a mid cap fund or large cap fund, diversified fund or sector fund, active fund or passive fund, equity fund or balanced fund etc., and what differentiates one fund from another – i.e. type of underlying security, investment style etc. would help you gauge risk and return associated with them. Read our past article on choosing an equity fund to know the various types of equity mutual funds out there.
2. Linking investments to market levels instead of your goals – It would not be surprising to know that a good number of people make investment decisions based on market moods rather than based on their investment goal. However before you buy mutual funds, you should have an asset allocation strategy guided by your investment goals. By having a strategy for investing you avoid letting emotions get the best of you and your money. It also helps avoid duplication of portfolio which happens when one buys several funds for the purpose of diversification but they all have similar portfolios. This can lead to overexposure to risk. Asset allocation is the key to having a robust and effective investment portfolio.
3. Blindly chasing performance – In mutual fund investments, past performance is no indicator of future performance. When investors buy mutual funds, the mutual funds schemes performance in any advertising material is always accompanied by this disclaimer, as directed by SEBI. Yet the appeal of performance numbers is so strong that many investors might be pleased using performance as the only criterion for choosing their fund.
This is not to dismiss the significance of track record. However track record makes sense only when a fund’s performance over different market cycles is studied, in comparison with its benchmark and peers, not in isolation. Often new investors fail to consider performance in relation with market condition and peers, and end up drawing incorrect conclusions.
Say you come across a fund that clocked 15% returns annually in the last 5 years. Should you be impressed? Depends. If its benchmark returned 19% in the same period and the average return of its peers was 20% then that fund is an underperformer! Or suppose if a fund that returned 20% in the 5 year period just gave 8% in the 3 year period, should you be disappointed with it? Not if its benchmark gave 5% returns and the average return of its peers was 6% in the same period.
However even if track record is impressive, it is risky to go with a fund for that alone because a fund’s performance can tumble after years of illustrious track record. So it is important to dig deeper than performance numbers. Find answers to questions like – is the mutual fund serious about managing investors’ money well or only in gathering it (AUM)? Take cue from matters like their attitude towards educating investors, lowering costs, innovating to make investing simpler, convenient etc. Do the sponsors of the mutual fund enjoy a good reputation? Do they emphasize on a research process or is fund manager the star? Of course, this might take the effort of a few days but it will be worth it. After all it’s about your hard earned and harder saved money.
4. Underestimating the expense ratio – To manage investors’ money properly and give them good returns over time, mutual funds do research on quality securities like equity shares; bonds etc. and employ their money in them. To do this function every mutual fund levies a charge on mutual fund schemes, known in industry jargon as Expense Ratio. Expense ratio which is the charge deducted from the net assets of a fund, impacts your returns. Higher expense ratio lowers returns. Rarely do investors include expense ratio in their criteria for evaluating mutual funds. If all else is the same investors should ideally buy mutual funds that have lower expense ratio. The impact of expense ratio is greater in long term investments due to the effect of compounding. Read our previous QED article for more on the impact of mutual fund expense ratio on your returns.
In our view, you should necessarily do your homework before you buy mutual funds. Take the assistance of a financial advisor who can guide you in creating a strategy, understanding products and keeping tab on investments already made.