Avoiding the Top 5 Mutual Fund Mistakes That Can Cost You Big
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Chasing Recent Top Performers
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It's tempting to invest in mutual funds that have delivered high double-digit returns, hoping their dream run will continue. Unfortunately, this strategy often backfires. Top-performing funds change frequently, and chasing last year's winners can lead to a lot of portfolio churn without delivering significantly better returns than a simple index fund.
Looking at the top equity funds over the past 10 years, we see a diverse mix of sectors, themes, and market caps topping the charts. Investing Rs.100,000 each year in the previous year's top performer would have resulted in returns only slightly better than investing the same amount in the Nifty 50 or Nifty 500 indexes. And the index investments would have come with less volatility and fewer buy-sell transactions.
Switching to a higher-volatility index like the Midcap index would have provided significantly better returns than the performance-chasing approach. The data suggests there are better alternatives to constantly chasing the latest top performers.
Investing in Sectoral and Thematic Funds
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Sectoral and thematic funds can be tempting due to their short-term outperformance, but they also carry higher risks. Predicting which sector or theme will be the next top performer is extremely challenging, as the leadership keeps changing.
Analyzing the top-performing sectors and themes over the past 10 years, we see a lot of churn. In over 70% of cases, the top-performing sectors from one year underperformed the Nifty 50 in the following three-year period. The same trend holds true for thematic funds - the top-performing themes and funds change frequently.
Picking the right sector or theme is best left to the fund managers, whose job it is to identify emerging opportunities. As an investor, it's wiser to stick to diversified equity funds, which will naturally have exposure to the sectors and themes that are performing well.
Heavily Investing in Mid-Cap and Small-Cap Funds
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During bull markets, mid-cap and small-cap funds tend to grab a lot of attention due to their impressive returns. Over the past year, the Nifty Midcap 150 and Nifty Smallcap 250 indexes have risen 27% and 29%, respectively, outperforming the 19% gain in the Nifty 50.
However, these funds also carry higher risk. Looking at the five-year rolling returns, the midcap index has delivered the best performance, but it has also been the most volatile. The small cap index, on the other hand, has been highly volatile without delivering superior returns.
Investors who can't stomach the ups and downs should stick to diversified equity funds. If you do want to allocate to mid-caps and small-caps, limit it to no more than 30% of your portfolio to manage the increased volatility.
Not Reviewing Your Portfolio Regularly
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Periodic portfolio reviews are essential to identify and address issues before they become problematic. For example, I had invested in a tax-saving fund in 2014 that outperformed the benchmarks for the first three years. However, from 2018 onwards, it started underperforming. If I had reviewed my portfolio regularly, I could have stopped the SIP and exited the fund much earlier, potentially boosting my overall returns.
Portfolio reviews should go beyond just looking at underperforming funds. You should also check your asset allocation, fund overlap, and whether the fund strategies have changed over time. Tools like the CAMS Fund Report Card and Portfolio Health Check can help you analyze your portfolio and identify areas for optimization.
Not Starting with a Financial Plan
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Many investors start investing without a clear financial plan in place. This is akin to going on a vacation without deciding on a budget or destination. Without a plan, you won't know how much to invest, whether your SIP amounts are sufficient, or when to exit your investments to meet your goals.
Financial planning should start with building an emergency fund and securing adequate insurance coverage. Only then should you focus on investing to achieve your specific goals, whether it's saving for a house, retirement, or your child's education. Knowing your target corpus, expected returns, and inflation rate will help you determine the right investment strategy.
A well-crafted financial plan provides a sense of direction, keeps you on track, and helps you stay motivated. It's a crucial first step before diving into mutual fund investments.
Other Mutual Fund Mistakes to Avoid
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In addition to the top five mistakes, there are a few other common pitfalls to watch out for:
* Investing in regular plans: Regular plans have higher expenses due to distribution commissions, leading to lower returns compared to direct plans.
* Investing in the IDCW (dividend) option: The IDCW option is less efficient than the growth option, as the payouts are irregular and taxable.
* Investing in NFOs (new fund offers): New funds lack a proven track record, and the lower NAV does not necessarily mean better returns.
* Investing short-term money in equity: Equity investments require a long-term horizon of at least 5-7 years to mitigate the risk of short-term losses.
By avoiding these common mistakes and following a disciplined, well-planned investment approach, you can maximize your chances of achieving your financial goals through mutual fund investments.
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