The mutual fund industry in India manages assets worth an estimated Rs. 21.41 trillion as per AMFI data calculated till the 31st of October 2017. This might seem like a huge sum of money but in comparison to developed markets, mutual funds are still an emerging market. This becomes clear when you compare this to the US mutual fund industry which manages assets valued at US$ 16.34 trillion as per data recorded in 2016. The good news however is that India’s mutual fund sector is growing fast thanks to the entry of increasing numbers of retail investors especially from India’s smaller cities. However, it is important to remember that when starting something new, there are bound to be mistakes and new investors tend to commit a few common ones that can be easily avoided. The following are five of the common and easily avoidable mistakes that occur in mutual fund investments.
Excessive Focus on Expense Ratio
Novice investors who do cursory research into mutual fund investments via the online route may find many experts extolling the virtues of low expense ratios. That’s how many novice investors end up searching for and investing in funds with the lowest expense ratios such as ETF and index funds. Unfortunately, though this focus on low expense ratios works well in developed markets such as the US, the same does not hold true in India, at least for now. In developed capital markets like the US, historical data shows that passively managed funds have consistently performed better than actively managed funds. However, in India’s growing economic landscape, capital markets have huge growth potential which allows actively managed funds on average perform much better than index funds and ETFs. Thus new investors would be better off opting for an actively managed diversified equity fund as compared to a passively managed fund in the present day situation.
Investing in NFO
NFO or new fund offers in India have increased greatly over the past couple of years. Many new investors are drawn into these thinking they can buy units at low prices (face value is usually Rs. 10) and book profits quickly at a later date. Unfortunately, though this strategy might work in case of an IPO (initial public offering), it often fails to be equally effective in case of an NFO. Units of a fund being offered through a NFO have no underlying assets or existing investments hence the face value in itself is not cheap or expensive. Only when the fund starts making investments does the actual value of the fund emerge. What’s more is that a new fund does not feature any past performance data to help determine the investment style and NFO investors often do not receive any special discounts for their investments either. In effect, a NFO investment is a potentially high risk equity investment with uncertain returns potential hence these mutual fund investments are best avoided by novice investors.
Opting for Dividend Option of Mutual Funds
Stock market investors often opt to redeem their shares after the company has distributed a dividend. This is because in most cases, when a company distributes dividends, it shows that the company’s finances are strong and profitable, which in turn drives the share price upwards. Unfortunately the same does not hold true for mutual fund units. This is because the dividends from a mutual fund are paid out of the AUM of the fund and the NAV of the mutual fund units decreases by the same amount as the per unit dividend disbursed. More importantly, mutual funds work best if you stay invested for the long term and allow the power of compounding to work in your favour. Thus instead of buying and redeeming units of different funds again and again in order to book profits, new investors should focus on long term capital appreciation by investing in the growth option of mutual funds.
Redeeming at the Slightest Sign of a correction
Panicking is perhaps most common mistake that a novice investor makes. A majority of new investors enter into capital markets when they are at record highs and at the sight of the slightest sign of a correction they redeem their investments often at a loss. Mutual fund investments can never be successful this way as these investments work best only and only if an investor seeks to make investments over the long term. Therefore instead of panicking when the markets undergo a correction, new investors should seek to stay invested in order to benefit from the compounding benefits offered by mutual fund investments in the long term.
Understand Mutual Fund Investment Risks
Investing in Thematic Schemes
Some new investors seem to think that they should invest cheaply in the sector that has recently witnessed the lowest level of growth or negative growth and then redeem for a profit as soon as the sector recovers. Though it seems like a good plan, this strategy might not work unless you have a good understanding of how the specific theme or sector works. Most thematic funds operate on the principle of business cycles and many of them are launched when a particular sector is doing well. Subsequently when the cycle reverses and the sector corrects itself, you might be stuck holding on to an investment that might take a long time to provide you with commensurate returns. Instead of going for such an investment, new investors should try investing in funds with diversified portfolio which provides superior balance between risk and returns.
How to Avoid Common Mutual Fund Investment Mistakes
Investing in mutual funds is inherently risky as they are market linked. Therefore individuals should take adequate steps to ensure that they manage the risk of their investments. While sticking to conventional wisdom regarding diversification and understanding individual risk tolerance are a good starting point, investors should also account for changing life stage as that too will eventually affect their investment selection. But most importantly investors, especially new ones, need to take the time to understand at least the basics of investing in order to receive the maximum benefit from their investments.
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