5 Most Common Mutual Fund Investing Mistake And How To Avoid Them

When you buy mutual funds remember that it is not an off the shelf product that you are buying. On the contrary, it is a solution that you are looking at and expecting that these mutual funds can help you meet your long term goals. Quite often investors tend to get disappointed with the performance of their mutual funds not realizing that their approach was conceptually wrong. Here are five common mistakes you must avoid when investing in mutual funds.

1. Buying too many mutual funds randomly…

To be fair, there are two mistakes that you are committing here. Firstly, you are buying too many funds. If you create a portfolio of many different schemes, it is hard for you to monitor and there is no value addition. Your overall mutual fund portfolio should never exceed 8-10 funds.   That is what you can effectively monitor. The second type of mistake is to buy funds randomly just because you have surplus funds. Instead, start off with your financial plan. Once your goals are crystallized, work backward and design SIPs for each need. Ensure that every mutual fund that you own (equity, debt or liquid) is clearly mapped to a goal.

Also, you don’t need to work too hard to time your mutual fund. When you try to catch tops and bottoms, your returns can come down sharply even if you miss 2 or 3 such peaks and troughs. Treat mutual funds passively and let the power of compounding work over time.

2. Choosing dividend plans over growth plans…

If you are holding an equity fund for your long term goals, don’t make the mistake of opting for dividend plans. Dividend plans deplete the corpus whenever dividends are paid out and hence your overall wealth creation gets impacted. Instead, prefer to put money into growth plans as they are automatic compounders. Some investors argue that dividends are tax free in the hands of the investor, but now even equity fund dividends are subjected to 10% dividend distribution tax.

3. Not paying attention to the fund management team…

It is one thing to say that institutions are larger than people but the fund manager and his style matters a lot. Given a choice between two fund managers, opt for the fund manager who has been more consistent (lower standard deviation of returns). The good fund manager is one who has been consistent in past performance and held the core fund management team together. Holding the team together is a point most MF investors ignore. It has been observed in India that a good and consistent fund team has been the key difference to the fund’s performance. The more stable the team, the more stable the strategy. This continuity works in your favour.

4. Betting on thematic funds over diversified funds…

Sector funds and thematic funds may appear to be good at times but the downside risk can be equally nerve-wracking. You are into mutual funds for the benefits of diversification. Just for the allure of sectoral and thematic funds, you cannot ignore this basic principle. Sector funds are normally sold hard at the peaks of the sectoral euphoria like IT funds in 2000 and Infrastructure Funds in 2007. Opt for a diversified equity fund or a multi-cap fund for the long-term.

5. Focusing on returns and ignoring risk…

How do you choose between Fund A that has given 17% CAGR in 3 years and Fund B that has given 15%? The choice is obviously Fund A. Let us add one more complication. Fund A gives 17% with 40% standard deviation while Fund B gives 15% with 12% standard deviation. Now Fund B looks a better bet. Your focus should be as much on risk as returns. A fund manager earning higher returns by taking on undue risks is doing you a disservice. That is where measures like Sharpe and Treynor capture the risk-adjusted returns. You can also use measures like Fama and Jensen to evaluate how much of your fund’s outperformance is generated by your fund manager’s skills and how much by sheer chance.

The cardinal rule, to begin, is that your mutual fund portfolio has 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!