Top 8 most common mutual fund investing mistakes and how to avoid them

Investing in mutual funds without setting goals is one of the most common mistakes new investors make as the general tendency among is to buy mutual fund units whenever the investors have surplus cash

Mutual funds, especially equity mutual funds, have played a pivotal role in helping retail investors create wealth over the last 25 years since they actually became a distinct asset class in India. Of course, mutual funds are not just about equity funds. There are debt funds, liquid funds, arbitrage funds, and balanced funds. But what is more important for you is to understand and avoid the mutual fund investing mistakes that new investors tend to make.

WHAT ARE SOME OF THE COMMON MUTUAL FUND INVESTING MISTAKES?

1. Investing in mutual funds without setting goals

The general tendency among many investors is to buy mutual fund units whenever they have surplus cash available with them. That is not a very scientific way of doing it. Remember, your mutual fund investment is part of your overall financial plan. Hence, any allocation to equity or debt mutual funds must be designed within the framework of your overall financial plan and aligned to your inflows. After all, your financial plan is aligned to your long term, short term and medium term goals and mutual fund investment is just a means towards an end. There must be a method to the madness.

2. Trying to time the market with mutual funds

It is quite common for investors to look at mutual fund as an alternative to buying direct equities. That misses the bigger picture. You invest in mutual funds with a view to create wealth systematically over the long run. Hence, it is pointless trying to time the market because it is practically not possible and it is also not meaningful in the long run. What matters when creating your mutual fund is time spent in the market and not timing the market! The longer you adopt a systematic approach to investing and the longer you stay invested, the more likely you are to create wealth. Always prefer the discipline of systematic investing over the allure of lump-sum investing.

3. Choosing dividend plans for tax benefits

A common premise among mutual fund investors is that dividends are tax-free in the hand of the investor and hence it makes more sense to opt for dividend schemes. That is wrong for two reasons. Firstly, if you keep taking money out of your fund via dividends then your eventual wealth creation target gets delayed. Secondly, dividends are subject to dividend distribution tax, which reduces returns earned on your investment.

4. Not considering the fund manager’s performance before investing

It is easy to say that institutions are larger than the people but in a fund, the fund manager and his style does matter. Always focus on a fund manager who has been consistent in past performance. That is a point that most MF investors tend to ignore. In fact, in many cases, it has been seen in India that a good and consistent fund manager has been the key difference to the fund’s performance.

5. Taking more risks by investing in thematic funds

Sectoral funds and thematic funds are great ideas when the particular sector is the cynosure of attention. But the downside can be equally nerve-wracking. You are in mutual funds for the benefits of diversification. Just for the allure of sectoral and thematic funds, you cannot ignore this basic principle. Above all, remember that sector funds are normally sold hard at the peaks of the sector euphoria. IT funds in 2000 and Infrastructure Funds in 2007 are classic examples.

6. Not diversifying your portfolio properly

Assume that you invested in equity funds and the NAV appreciated over the last 3 years on the back of a solid bull market. Alternatively, your debt funds have now become 40% of your overall portfolio instead of 30% due to falling interest rates. Either ways it is time to reallocate your portfolio. Your advisor may tell you to persist with debt funds or equity funds but you must stick to your allocation discipline.

7. Investing in a large number of mutual funds

Any large portfolio becomes unwieldy and an unwieldy portfolio is hard to manage and to monitor. Beyond a point adding more schemes does not add value. It does not lead to risk diversification but only to risk substitution. Ideally, a mix of 5-6 schemes should serve your purpose. The more you keep adding schemes, the more you need to track in terms of performance and risk metrics.

8. Not factoring in risk before investing

This is a common mistake committed by most mutual fund investors. They focus on whether the fund in question has beaten the index and outperformed its peers. The actual focus should be on risk. A fund manager who earns higher returns by taking on undue risks is doing you a disservice. That is where measures like Sharpe and Treynor assume significance as they capture the risk-adjusted returns rather than pure returns. Also, use measures like Fama to evaluate how much of your fund’s outperformance is generated by your fund manager’s skills and how much by sheer chance.

Creating a mutual fund portfolio is a complex task. To begin with, your mutual fund portfolios have to be built within the framework of your overall financial plan. But creating a mutual fund portfolio is just the beginning. Monitoring and tweaking it continuously is the harder part!

Disclaimer: The above opinion is that of Mr. Vaibhav Agrawal (Head of Research & ARQ - Angel Broking) & is for reference only.