Five Mutual Fund Investing Traps To Avoid
Mainly aided by the explosive growth in SIP's (Systematic Investment Plans), the Indian Mutual Fund industry has registered explosive growth in the past three years. The total assets under management now hover around the Rs 23 lakh crore mark, with monthly SIP inflows exceeding Rs. 7,000 crores further bolstering their position as a preferred investment vehicle for the progressive Indian investor. There are, however, a common set of traps that Mutual Fund investors (seasoned and new alike) keep falling into. Here are the top five that you need to avoid at all costs.
The "Past Returns" trap
Does your "fund selection" methodology entail sorting various schemes by 1-year returns, and jumping in with both feet? Like many investors who dove into midcap funds at the start of the year, you're bound to feel the heat sooner than later. The reason why this is a deeply flawed technique is quite simple to understand: all asset prices go through cycles. If you only invest based on high shirt-term past returns, you'll always buy into asset classes at the wrong point in their cycles. Quit employing this oversimplified approach towards portfolio building.
The "In and Out" trap
It's common for NAV's of all Mutual Funds to fluctuate or even stay stagnant for frustratingly long bouts of time. If you grow impatient and start moving things around every time asset prices fluctuate, you'll not only end up bearing high transaction costs and taxes - you'll also continually miss out on the high return phases that would have otherwise accounted for the lion's share of your wealth creation from these funds. Review often, but don't be in a hurry to chop and change things unless there are drastic changes in underlying fundamentals that drove your investment decision.
The "Lack of Understanding" trap
Can't tell credit risk from interest rate risk? Unaware of how dynamic asset allocation funds work? Unclear about the potential upsides and downsides of small cap funds? You're in for some severe heartache in the future. Mutual Funds may be 'shut and forget' investment vehicles to an extent - but that doesn't necessarily absolve you from your duty to understand their basis concepts, and the risks associated with them. Make sure you aim for an above average awareness of how various types of Mutual Funds really work, and what drives their returns (or lack of returns!)
The "A little bit of Everything" trap
Do you have an unfathomable attraction to NFO's? Do you insist on investing little sums of money in every Mutual Fund scheme that catches your fancy? You'll likely end up overdiversifying your portfolio to the extend that you cancel out most of the 'alpha' or outperformance that you could have achieved. The most effective portfolios are compact, well-organized and consisting of no more than 5-10 schemes. Don't scatter yourself across a multitude of funds.
The "Tax Efficiency is everything" trap
While tax efficiency of your returns is undoubtedly a worthy consideration, making it the sole driver of your investment decisions is a trap. For example: you may be a retired investor who can afford to take very little risk, but you invest purely in equities because they're more tax efficient than debt funds. Or - you choose not to take profits at the obvious peak of a bull market cycle, simply because you'd like to avoid booking capital gains. This is akin to missing the woods for the trees.
