7 Mistakes to Avoid While Investing in Mutual Funds

In this post, let’s look at some of the common pitfalls about investing in mutual funds.

1. Mutual Fund Means Equity Mutual Funds. Many of us get attracted to mutual funds during periods of bull run in the equity markets. We are attracted to high returns of equity funds. Therefore, for many of us, mutual fund means equity mutual funds. Not correct. Mutual funds come in multiple variants. And equity mutual fund is merely one of the variants. There are debt funds, hybrid funds and gold funds too. 

Within this broad classification, there are many sub-variants. For instance, an equity fund can be a large cap fund, mid cap fund, small cap fund or a multi-cap fund.  It can be a sector fund or an asset allocation fund. There can be many more sub-variants based on the type of securities a fund manager invests in and the style of investment. Similarly, a debt fund can be a liquid fund, ultra-short term fund, short term fund, dynamic bond fund or a long term fund. It can be a credit opportunity fund or a gilt fund.

Equity funds are inherently volatile. Debt funds, on the other hand, are not as volatile owing to the kind of underlying securities. NAV of a debt mutual fund will not fluctuate as much as NAV of equity fund scheme. Depending upon nature of underlying security, the amount of risk involved will also vary across different categories of mutual funds. For instance, a liquid debt fund won’t be as risky as a mid and small cap fund.

You must choose the funds based on your financial goals and your risk tolerance. So, if you are not comfortable investing in equity mutual funds for long term goals, you can consider investing in a hybrid fund (balanced fund or a MIP). When it comes to mutual fund, equity funds are not your only choice.

2. Selecting Equity Mutual Funds for Everything. Taking the earlier point forward, if you limit your investments in mutual funds to equity mutual funds, you are bound to make mistakes. No matter how rosy the market outlook is, you must never choose an equity fund for a goal which is say 6 months away. You must pick up a debt mutual fund or any other debt product such as a fixed deposit for such short term goals. You must invest in equity funds only for goals which are many years away.

3. Lower NAV Is Better. Given a choice between fund scheme A with NAV of Rs 50 and fund scheme B with NAV of Rs 100, which scheme would you choose? If you pick up funds solely on the basis of low NAV, you will pick Scheme A. It is not a prudent choice. It is not that Scheme A is bad. I am merely saying low NAV is not a good enough reason to pick Scheme A over Scheme B.

Let’s see why. You invest Rs 50,000 in both schemes. Under Scheme A, you will be allotted 1,000 units while you will get 500 units under Scheme B. Let’s assume both schemes return 10% over the next year. NAV of scheme A will grow to Rs 55 while NAV of scheme B will grow to Rs 110. Total value of your investment will be Rs 55,000 in either scheme. Hence, what matters is the return. If both schemes offer the same return, NAV does not really matter. Focus on aspects such as long term past performance, fund’s track record in generating excess return and managing downside risk, and fund manager vintage and pedigree.

4. Rear Mirror Driving. Good past performance tells you a lot about fund scheme. Everything else being the same, I will pick up a fund scheme that has delivered better returns over a scheme that has not done well. However, do not get fixated with returns. For instance, there might be a phase of 3-4 years when mid cap & small cap funds or an infrastructure sector fund may have outperformed large cap funds. If you were to focus only on short term performance of last 3-4 years, you will load your portfolio with mid & small cap funds or banking sector funds and shun large cap funds completely. I have seen this happen. 

It is like having a 100% equity portfolio (and no debt) when equity markets are doing well. There will be phases when equity will outperform debt. And there will be phases when debt will outperform equity. You need to get your asset allocation right. Similarly, mid cap funds may have done very well over the last few years. However, this outperformance may not go on forever or may even reverse. Therefore, it makes sense not to go overboard on specific category of funds. Within equity funds choose a large cap, mid cap and a multi-cap fund. If you have good knowledge about a sector, you can pick up sector fund too. Strike a balance.

5. Chasing the Best Mutual Fund Scheme. There is no such thing as the best mutual fund scheme. If you are trying to find one, you will most likely keep chasing returns. You may pick up a scheme which has given the best returns in the last one year. Good enough. What is the guarantee that this fund will perform the best in the next year too? There is none. Next year, the baton may pass to some other fund. Will you switch to the other fund next year? Such approach is likely to cause undue anxiety, cause frequent churning and may even compromise your investment discipline. Pick up good funds in line with your goals. As long as you are on target to meet your goals, it does not matter if your fund has given the best returns over the last year or not.

6. Too Many Funds in Your Portfolio. Recently, I reviewed MF portfolio of a client. Two year old portfolio had almost 60 funds. What does having too many funds achieve? Diversification? If one fund underperforms, some other fund will make up for it. I don’t think so. Mutual funds invest in multiple securities and hence achieve diversification automatically.

Beyond a point, having too many funds will only clutter your portfolio. It will make portfolio review much cumbersome. Having to review performance of 60 funds is likely to make you postpone the activity. With so many funds, you are also less likely to take difficult decision to exit an underperforming scheme. 

Rather than selecting too many funds, focus on getting your asset allocation (breakup of investment across various asset classes such) right. Pick up a few good funds and relax. If you follow goal based planning approach, you can pick up a fund or two for every goal and that should be enough.

7. Lack of Investment Discipline. If you invest in equity funds when the markets are hitting new highs and exit when the markets are touching fresh lows, you are unlikely to make money investing in equity funds. And this happens with a lot of retail investors. We remain skeptical initially but can’t resist after hearing so many positive stories (along with propaganda) about how others made money investing in equity funds. We enter equity markets (or funds) hoping to make quick money. Equity markets are volatile. When markets go down subsequently, it is likely to leave you disappointed and disillusioned with equity investments. With such approach, you won’t make any money investing in equity funds. Equity investments are meant for long term goals. You must learn to live with short term volatility. As long you have faith in long term prospects of the economy, stay invested and keep investing. Take the SIP (systematic investment plan) route to MF investments and put your investments on auto mode. You may do better if you have some sense of timing but SIP approach is simple and easy to execute.