- Comparing NAVs while selecting mutual funds is the most common mistake that investors make.
- Another one being overlooking investment objective, which states the fund’s investment mandate and its asset allocation strategy.
The outstanding performance of equity markets in India along with the advent of online investment platforms has attracted fresh mutual fund (MF) buyers like never before.
Aided by inflows from fresh MF investors, total industry-wide AUM (assets under management) held by individual investors rose from 47.1 percent in May 2017 to 52.1 percent in May 2018. A bulk of these fresh mutual fund investor inflows went to equity schemes as evident from the fact that investment by individual investors’ increased by 46.2 percent in between May 2017 and May 2018.
While increasing participation of retail investors in equity markets is certainly a good sign for the overall economy and financial inclusion, fresh new MF investors are usually prone to certain common mistakes. Here are some of the most common ones that they should avoid for the sake of their own financial mistake:
Comparing NAVs while selecting mutual funds
Many investors, including first-timers, wrongly believe that fund with lower NAV is cheaper than others. Investment advisors also promote this myth to upsell New Fund Offers (NFOs), which are offered at face value of Rs 10. However, a fund’s NAV can be high or low due to multiple factors. For example, as the NAV of a fund depends on the market prices of its underlying assets, the NAV of a better managed fund will grow faster than other funds. Similarly, a relatively newer fund will have lower NAV than its much older counterparts as it had lesser time to grow.
Instead of using NAVs for fund comparison, use the past performances of funds along with their future prospects of out-performing their peer funds and benchmark indices for selecting mutual funds.
Opting for dividend option to earn dividends
Many mutual fund investors consider mutual fund dividends as some sort of a windfall income. Many financial advisors take advantage of this misconception to sell funds which have just declared dividend. However, what investors fail to realize is that mutual fund schemes pay dividends out of their own AUM. This means that the mutual fund dividends are paid out of their investors’ own money. This is why the NAV of a fund gets reduced by the dividend amount after the dividend record date. Moreover, the dividend amount is calculated on the face value of a fund, not on its NAV. For example, if a fund having an NAV of Rs 30 declares a 30 percent dividend, it will pay a dividend amount of Rs 3 (30 percent of Rs 10, its face value) and its NAV will come down to Rs 27 after the dividend record date.
Hence, never invest in the dividend option of a mutual fund in the hope of earning a windfall income. Instead, opt for its growth option to benefit from the power of compounding.
Overlooking investment objective
All mutual funds are required to publish their investment objectives in their sale brochures, leaflets, etc. The investment objective states the fund’s investment mandate and its asset allocation strategy. With its help, prospective fund investors can find out whether a particular fund suits their financial goals and risk appetite. However, most fresh mutual fund investors tend to ignore the investment objectives, which may leave them with a wrong fund for their financial goals and/or risk appetite.
Expecting unrealistic returns
Most first-time mutual fund investors invest in equity mutual funds during bull market. Exceptional returns generated during bull markets attract fresh investors expecting such performances to continue for eternity. This leads many to compromise their liquidity by channeling their entire investible surplus into equity funds. Worse, many may also end up investing in equity funds for their short-term goals. However, many investors in this situation would be forced to liquidate their investments as and when the markets enter correction/ bearish phase.
Hence, you must select mutual funds on the basis of your risk-appetite and time horizon of financial goals; and not on the basis of their performance in the recent past. While comparing the funds’ returns, take into account their annualised returns generated over the last 3, 5 and 10 (if available) years. Align your mutual fund investment with specific financial goals like building corpuses for your retirement, children’s education, marriage, down payment for home loan or car loan etc. Stay invested in your funds till you realise your financial goals and/or as long as they continue to outperform their benchmark indices or peer funds.
Not diversifying enough
Many fresh mutual fund investors invest their entire investible surplus in just one mutual fund. Similarly, many restrict their investments to a particular theme or sector, which generated outstanding returns in the near past. Such investors end up concentrating their investment risk to just one fund management team or a particular sector/theme. Instead of putting all eggs in one basket, reduce your fund management and market risks by investing in schemes across various fund houses. Thus, even if one or some of your funds underperform, others will save the day by delivering higher returns.
Manish Kothari is a director and head of mutual funds at Paisabazaar.com