Today mutual funds have become one of the most popular investment avenues for investors given the wide range of products based on varied investment requirements. Before investing in a mutual fund, here are 10 mistakes that investors tend to make and why it is important to avoid them.
1. Treat mutual funds like equity shares.
Many novice investors are so allured by the current high-short-term returns that they carry their perception of stock investing to mutual funds as well. They have forgotten or aren’t aware that a mutual fund is a portfolio of stocks built after rigorous research done by expert fund managers.
A stock can be overvalued or undervalued but you cannot apply the same analogy to a mutual fund. This is because it is the job of the fund manager to select valued stocks appropriately as per the objective of the portfolio. So, buying and selling of mutual funds for trading purposes is an investment mistake, which investors need to avoid as much as possible. A mutual fund can never give returns equivalent to a stock and nor will the potential losses be as steep.
2. The lower the net asset value (NAV) of a scheme, the better.
Every investor knows that to earn good returns, the mantra is “buy low and sell high”. And this is a concept that they try to apply to every investment product. Many investors invest in new fund offers (NFOs) with the hope to invest at its base price as low as INR 10. But they fail to understand that even for an NFO, the price at which it buys its underlying securities is the same for every other player in the market.
The NAV at which you are able to buy the mutual fund units is not important, rather it is what price the fund manager buys the underlying securities at that is important.
Let us try to understand this with the help of an example of two funds to see how their NAVs perform. Scheme A (Mid-Cap Fund) was launched on January 25, 2017 at a base price of INR 10 per unit and on the same day, the NAV of Scheme B (midcap fund) was INR 31.59. If someone had invested in Scheme A as against someone who had invested in Scheme B, then the NAV and scheme returns would differ.
One can see from the above table that the NAV of Scheme B was more than three times the NAV Scheme A when it was launched. Besides, Scheme B was able to deliver higher returns than the other scheme. But this doesn’t mean that you should refrain from investing in the NFO. There are NFOs which have delivered higher returns than their peers that already exist.
The point is you should never invest in mutual funds just because the NAV is low. The older the fund becomes, the higher the NAV will be.
3. Guaranteed returns.
Everyone wants to be guaranteed returns, irrespective of what investment they choose. But there are no guaranteed returns in mutual funds. Every mutual fund commercial warns you that ‘mutual funds are subject to market risk’; it means that the returns generated from mutual funds will fluctuate as per the volatility in the market.
Even debt funds, which are considered by many as risk free, may not provide guaranteed returns regularly. Yes, debt funds are safer than equity funds, but that doesn’t mean they can give you guaranteed returns.
Let us take the example of a Liquid Fund which is considered to be one of the safest categories in the mutual fund universe.
The above table clearly shows that even the safest category of mutual funds don’t give the same returns every year. So, expecting a guaranteed return from a mutual fund is wishful thinking.
4. Looking only at the past performance.
Past performance of a mutual fund does give us a fair idea of how efficient the fund manager was in picking up the right stocks at the right time. But that was in the past. There is no guarantee that the fund will repeat its past performance in future too.
Let us take an example of two funds where the performance has changed over a period of time. The compound annual growth rate (CAGR) of Scheme A and Scheme B for two different sets of periods (ending December 31, 2017 and ending December 31, 2020) have been considered.
From the above table it is clear that Scheme A which performed better than Scheme B for three periods ending in 2017 was not able to deliver the same performance after three years. So, the past performance should not be the only criteria while selecting the fund for investment.
Investors should scrutinize every aspect of funds rather than depending only on the past performance.
5. Comparing funds.
While comparing the performance of funds many investors tend to compare apples with oranges. They just focus on how much return the fund has given without considering whether the funds belong to the same category and other aspects of the funds. Comparison should be done with the right peers and the right benchmark.
You cannot compare the performance of a small cap fund with a large cap fund, as both the funds invest in different sets of stocks. For example, you cannot compare the performance of SBI Bluechip Fund with SBI Small Cap Fund as both of them invest in different pools of stocks. SBI Bluechip Fund should be compared with other large cap funds and its respective benchmark, i.e., the S&P BSE 100 TRI.
Similarly, SBI Small Cap Fund should be compared with funds in the Small Cap category and S&P BSE Small Cap TRI.
6. Redeeming too early or stopping systematic investment plans (SIPs) based on market noise.
The dictionary meaning of “panic” is “sudden uncontrollable fear or anxiety, often causing wildly unthinking behavior”. This anxiety and unthinking behavior, many times, makes us take irrational or even harmful decisions for ourselves. The noise created by the market makes one panic. And when we are in panic, without thinking much, we follow what others are doing even though it is not necessary for us to do so. The market has always rewarded those investors who have remained patient with their investment.
Questions that plague everyone include: “Are the markets overheated?”, “Should one exit?” Whereas the question should actually be: “Do I need money in the short-term?”.
If your goal is long-term there is no need to tinker with the investments, as markets would go up and down.
7. Investing without a goal or asset allocation in mind.
Investing without a goal is like a car without a steering wheel and unfortunately most of the people invest without proper planning. A goal-based investment helps investors to decide on the right asset allocation required for their portfolio.
Following an asset allocation-based approach prevents an investor from getting affected by the distractions in the short term and at the same time, they can make wise decisions and reap the benefits from opportunities provided by the market. Specifically, mutual funds are goal-oriented instruments.
8. Choosing the dividend option for regular income.
One popular option chosen by many investors who seek a regular income (specifically retired investors) is the dividend option. But the dividend provided by mutual funds is quite different from the dividend received from stocks. In the case of equity, the dividend is declared from the profits which arise from the sale of products or services of the underlying company.
Whereas in mutual funds, the profits are derived purely from the sale of securities as well as the net appreciation of the securities held. It is this very reason that prompted the markets regulator to change the nomenclature from “dividend” to “IDCW”, i.e., income distribution and capital withdrawal. However, this has not been completely understood by investors and many still continue to hold investments under the IDCW option.
9. Investing without consulting a financial advisor.
Many investors consider consulting a financial advisor as an unnecessary cost. They think investing is just a one-time activity and for that they don’t need any financial advisor. They seek advice from their friends, colleagues and relatives and some just invest on the basis of tips received from social media.
Some even do it themselves by looking at the past performance of funds, which we have already depicted as a perilous exercise. Investment is a lifetime process which changes at every stage of life. A financial advisor will not only guide investors in making the right asset allocation as per their needs but will also help in gaining the proper risk-adjusted return. So unless you are armed with full knowledge, you should always take the help of an expert.
10. Treating debt funds like a bank fixed deposit (FD).
Fixed income instruments, like bank deposits, bonds etc. are loans which the investor gives to the bank and in return, the bank periodically pays a fixed rate of interest for it. A debt mutual fund is a holder of these instruments and in turn, it receives interest. However, the returns for investors vary as it is a basket of instruments.
There are two important things to bear in mind while investing in debt funds – you are exposed to credit risk as well as interest rate risk. An investor may or may not get the same amount of return as the debt mutual fund valuation keeps on changing based on the interest rate scenario in the economy. There are, however, two advantages of debt mutual funds – firstly, they are liquid and can be encashed at any time and secondly, the returns are tax efficient, if held for more than three years.
It is very important that you are thoroughly informed about the products in which your money is being invested. Not having adequate knowledge about your investments will lead you to commit mistakes throughout your investment journey. Knowing about the common mistakes made by the mutual fund investors, on the other hand, could help you in your investment journey.