6 Mistakes that New Mutual Fund Investors Must Avoid

Mutual fund investments in India are on the rise and there’s no denying in this. In fact, recently released AMFI (Association of Mutual Funds in India) data has shown that AUM of all mutual fund companies in India across all fund categories cumulatively grew 29.13% year on year between September 2016 and September 2017. Some of the reasons ascribed to this growing interest include increased investment from smaller investors, historic low ROI on fixed income instruments such as FD, easy accessibility to mutual fund investments and so on. Whatever else this data might say, one thing is certain – new investors are entering into various types of mutual fund schemes in droves and many of them are prone to the following six mistakes that must be avoided at all costs.

Investing based on Fund NAV

When describing NAV to a layman, investment advisors often mention that this is similar to share price and that NAV will change based on the performance of the fund. This explanation provides investment advisers with the perfect set up to pitch NFO (New Fund Offers) and mutual fund offers featuring a low NAV as they are “cheap” and offer growth potential. This, unfortunately, is the wrong approach to selecting mutual fund investments. NAV is in fact calculated by dividing the total assets less total liabilities of a fund divided by the total number of outstanding units. This newly launched funds or NFO offers will have a lower NAV as they have fewer assets, while older funds will tend to have a higher NAV as they have more assets. However, there is no guarantee that a new fund will perform better than an existing fund with a higher NAV. Thus instead of focusing on NAV, focus on the returns that the fund has managed to provide when selecting your investment. In case you are new to mutual funds, it might be better to stay away from an NFO and instead focus on existing funds that have a proven track record irrespective of their NAV.

Checking only Short Term Returns

In the previous section I have mentioned checking returns and many new investors base their investment on this however they make the classic mistake of just checking returns of the previous year. Mutual funds are market-linked instruments and this means their performance will be cyclical. When there is boom in capital markets, the value of your investment will increase, while during market busts your portfolio value will decrease. In case you focus on just the previous year, it will not provide you with an accurate picture of the fund’s prior performance. You should thus at least check the 3 year and 5 year returns of the fund to ascertain if your chosen fund has in fact been a consistent performer through various market cycles.

Making Excessive ELSS Investments

ELSS or equity linked savings scheme have become the new sweetheart for mutual fund investors as these provide the dual benefit of capital appreciation and tax savings. However new investors miss out a key fact when quantifying their investment – the 80C deduction limit. According to the provisions of the Income Tax Act 1961, the 80C Section has a cumulative deduction limit of Rs. 1.5 lakhs and includes popular tax saving schemes such as life insurance, ULIP, PPF, EPF, VPF, bank tax saver FD and ELSS. The key word to notice here is “cumulative” i.e. if you have already invested say a total of Rs. 30,000 in life insurance and EPF, then you will only get an additional benefit of Rs. 1.2 lakhs from your investment in ELSS. So instead of investing an excess amount in tax saver funds which have a lock-in period of 3 years, you can always choose to invest in an equity scheme after your tax savings-related considerations have been met. On average, large cap and multi cap equity schemes are capable of providing comparable returns which can be withdrawn tax free after holding the investment for at least 1 year.

Investing for Dividends

Some financial advisors are known to pitch dividend option of mutual funds to new investors. The rationale provided is that you can book returns ahead of time even if your funds are locked-in and mutual funds dividends are completely tax free so you just can’t go wrong here. If this seems to be too good to be true, you are right. Unlike share dividends which a company pays out of its profits, mutual fund dividends are paid out of your investments when there is capital appreciation. Therefore the NAV of the fund decreases by an amount equal to the dividend paid out by the fund. So you don’t get much long term capital appreciation on your investment as the beneficial effect of compounding is minimized to a large extent even if not completely eliminated.

Maintaining Insufficient Diversification

The old proverb “don’t put all your eggs in one basket” holds true for your investments too. Many new investors tend to put their entire investable surplus into just one or a single type of fund just because it has performed well in the past. However, according to market experts, the key to successful investing is in fact diversification and that can be achieved only if you consider investing in different types of funds across fund houses. This would prevent overexposure to a specific sector or fund management team. Thus, even if a single scheme underperforms, other schemes you are invested in would potentially continue to generate wealth.

Expecting Unrealistic Returns

New investors often start their investments when markets are witnessing a bull run and investments made at an earlier time are generating high returns. This often leads new investors to have unrealistic expectations from their investments such as expecting to book quick profits through equity investments. These are not realistic expectations as mutual fund investments work best when you are staying invested for the long term. In the short term especially in case of equity investments, markets often make corrections that might lead to a decrease in value of the investment. Thus, while making mutual fund investments, new investors should consider a long term horizon when investing in equities. For short term investment needs, debt mutual funds usually offer a more lucrative and effective investment option.

The Final Word

As more and more new investors enter into equity markets and capital markets reach historic high levels, new investors should consider using systematic plans to make their investments. Using mechanisms such as SIP would help mutual fund investors develop disciplined investment habits and ensure that their long term savings requirements are met.  Additionally by staying invested in the long term, systematic plans can provide investors with adequate opportunities to benefit from SIP features such as rupee cost averaging and power of compounding.