Avoid 6 common mutual fund investing mistakes

1. Investing in NFOs in order to buy units at par value: This is either a rookie mistake on part of the investor or deliberate mis-selling by the distributor or financial adviser. Par value of a mutual fund unit is meaningless, because the unit by itself has no value. The unit derives its value from the underlying of stocks or bonds or a combination of both. Funds whether NFO or launched some time back, invest in the same universe of stocks at market price. The absolute value of the unit at which the investor invests in the fund is in itself irrelevant. It is true that you can buy a larger number of units by investing in the NFO. But as discussed earlier, the unit by itself has no value. The growth in the Net Asset Value of the unit, over a period of time is relevant. Let is illustrate with a simple example. Mr. A invested Rs 10,000 in the Kotak Select Fund NFO in August 2009 and bought 1000 mutual fund units. Mr. B invested Rs 10,000 in the ICICI Prudential Dynamic Plan (Growth) at the same time. He bought 125 units of the fund at a unit NAV of 80. Though Mr A has 1000 units of the fund and Mr B only 125, the value of Mr B’s investment today is much higher. See the table below.

2. Funds with high NAVs are overpriced and funds with low NAVs are attractively priced: This is similar to the misconception described above. Mutual fund units are not stocks, where a low share price may sometimes, not always, mean that the valuation of the share is attractive. At the cost of repetition it is important to reiterate that, a mutual fund unit in itself has no value. It derives its value from the underlying assets in its portfolio. The NAV is nothing but the current market price of the total underlying portfolio assets divided by the number of units issued by the fund. If the value of the underlying portfolio goes up, then the NAV will go up and vice versa. In the above example, even though the NAV of the unit of Kotak Select Fund was only Rs 10 while the NAV of the ICICI Prudential Dynamic Plan was Rs 80, it does not mean that ICICI Prudential fund was overpriced. In fact, the ICICI Prudential fund gave better returns, as evident in the table above. The appreciation potential of a fund does not depend on its current NAV, but on the underlying portfolio and the investment management style of the fund manager.

3. Investing in funds which gave high returns last year: Recent performance is not always a good indicator of future performance. Paying too much importance to recent past performance and ignoring long term performance and other performance factors like, fund manager’s track record, portfolio composition etc is risky. You may be selling a good fund and moving to a not-so-good fund. Let us examine this with an example. In 2012 the SBI Emerging Business Fund, a mid cap fund, gave very high returns of over 56%. In January 2013, if an investor was tempted to invest Rs 10,000 in this fund, based on its 2012 performance, he or she would have made a loss of nearly 8% by the end of 2013. On the other hand, if the investor invested in the UTI Midcap fund, even though it gave 14% lesser returns in 2012 than the SBI Emerging Business Fund, he or she would have made a profit of nearly 10%. There are a variety of factors that determine future performance of a fund, like historical returns over various time scales, volatility, portfolio concentration risk, fund manager track record and investment style. One should not give too much importance to recent good performance, because mutual fund essentially is a long term investment.

4. Funds that declare high dividends are better: This is another misconception. The dividend that the fund pays is adjusted from the NAV. There is no benefit in getting a big dividend. The objective of mutual fund investment is to grow your wealth in the long term. You should be very clear about your investment objective.

5. Book profits in funds which are giving good returns, while hanging on to losers: It is the same mistake that a lot of retail investors in stocks also make. Greed and fear psychology takes over, and retail investors rush to book profits in funds that are doing well, in the fear that the value may go down in the future. At the same time investors hate to book losses, and hang onto losers longer than they should. As discussed earlier, mutual funds are essentially long term investments. By booking profits in funds that have performed well, you are giving up future returns. It is also very important that investors recognize funds in their portfolio that are not performing well. They should book losses in these funds and switch to funds that are doing well. Mutual fund investors should resist the urge of averaging the cost of poor performers, like some retail investors in stocks do, in the hope of getting better returns.

6. Allocating a big portion of the portfolio to thematic or sector funds: Investors sometime take a big exposure to thematic or sector funds, based on recent high performance. It is better to invest in diversified equity funds for long term financial objectives. Sector funds are exposed to sector specific risks, and as such are more risky than large cap or diversified equity funds. Over a long period of time, sector funds cannot outperform diversified equity funds. If you are investing in sector funds, you should ensure that you book profits at the right time. More importantly, if a sector is peaking in terms of valuations, it is not wise to enter that sector, even though recent performance of the sector fund will be very strong. As such sector funds are for investors with a lot of experience and expertise.

Conclusion

Investors should avoid these common mistakes when investing in mutual funds. Mutual funds are long term investments. By selecting a good fund or a set of good funds, and remaining invested in them over a long period of time, investors can create wealth in the long term. At the same time, it is very difficult to always spot a winner. Therefore, investors should monitor their portfolio on a continuous basis. If there are funds in his or her portfolio, that are not doing well over a given period of time, investors should not hesitate to book losses and switch over to good fund. If you have a good financial advisor, your job becomes that much easier.