How to avoid mutual fund common investing mistakes to get the best return: Part 2

In our post, How to get the best out of mutual funds by avoiding common mistakes: Part 1, we had discussed some common mutual fund investing mistakes like trying to time the market, investing in a large number of mutual fund schemes to diversify risks, monitoring the portfolio value on a daily basis and panicking in bear markets. These mistakes cause investors to get sub-optimal results from their mutual fund investments. In this post, we will discuss some more investing mistakes that you can avoid to get the best result from your mutual fund investments.

1. Never monitoring your portfolio performance:

   Many investors do not take sufficient interest in their own investment and instead rely on their financial advisors to tell them what needs to be done. Some financial advisors are diligent in reviewing their client’s portfolio on a regular basis and making suitable recommendations. Some financial advisors have told me that, even if they want to schedule portfolio review meetings with their clients, they cannot get time from their clients. There are many financial advisors who cannot devote time for monitoring individual client investment portfolios and instead call their clients, only if they have to sell something to them. Whatever the case, unless investors take interest in their own investment, they will not know if they are on track with their investment goals.
   
   Many a time financial advisors make investment recommendations in the context of specific market situations. When situations change, investors should review their portfolio and make suitable changes. For example, in certain conditions some sectors perform better than others. If you have invested in these sectors through thematic funds, you should plan your exit when conditions are no longer favourable. Similarly, some debt funds outperform others given a particular interest rate outlook, but they are likely to underperform when the outlook changes. If you monitor your portfolio on a regular basis, you will be able to detect these trend reversals and take suitable actions.
   
   It should be your financial advisor’s responsibility to review your portfolio with you at a regular frequency. If he or she does not do it on their own, then you should insist that your advisor schedule regular meetings with you to go over the portfolio.



2. Booking profits in funds which gave good returns:

   When investing in stocks, many a time investors have a price target in mind; investors book profits when the price target is reached. However, the same approach cannot be applied to mutual funds. The goal in mutual investing is not a price target, but your personal financial goals. Greed and fear psychology is again at play when 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. This is one of the worst mistakes that you can make.
   
   We have explained before in our blog that, unlike stocks, mutual fund schemes cannot over-valued or under-valued. The fund managers of your mutual fund schemes are continuously looking for growth or value opportunities. A good fund manager can generate good returns for investors over a very long investment period, short term volatility notwithstanding. By booking profits in funds that have performed well, you are giving up future wealth creation through the power of compounding. It is also very important that investors identify funds in their portfolio that are not performing well. They should exit these funds and switch to funds that are doing well.



3. Redeeming mutual fund investments before exploring other options in exigencies:

   There can be situations when we are faced with a sudden large expense and you do not have sufficient liquid funds to meet the expenditure. Sometimes mutual fund investors resort to redeeming their mutual fund units to meet such exigencies. Some investors may think that, they have already made a profit in these investments and so there is no harm done in selling. Redeeming your mutual funds, especially equity funds, to meet unplanned expenses can have a very adverse impact on your long term financial goals.
   
   Some investors are reluctant to breaking their fixed deposits to meet emergency expenses, because they do not want to incur premature withdrawal penalty and lose interest. If you look at the opportunity cost (future returns) of redeeming your equity mutual fund units, you will realize that it is much more than the lost interest and premature withdrawal penalty. However, breaking fixed deposits to meet an emergency expenditure is also not the best course of action.
   
   As part of good financial planning discipline you should set aside some emergency funds in a liquid fund to meet any exigency. In a situation where your liquid fund balance is not sufficient, you should have a pecking order of which investments to redeem when you are faced with such situations. Redeeming your equity funds should only be the last resort.



4. Ignoring debt mutual funds:

   An average retail investor usually associates mutual funds with only equity investments. For fixed income investments they rely either on fixed deposits or small saving schemes. However, debt mutual funds offer investors a large variety of choices to invest across a large spectrum of investment tenures and interest rate scenarios. For example, when interest rates are high, investors can get better returns by investing in fixed maturity plans and accrual based debt funds. When interest rates are falling, investors can get better long term returns investing in long term debt funds where fund managers take duration calls. In an uncertain interest rate scenario dynamic bond funds, where durations are actively managed by the fund managers, can give good returns. For investors who are willing to take some credit risks, corporate bond funds or credit opportunities can get extra yield compared to risk free investments. Liquid funds can get you much better income than your traditional bank account.
   
   Investors should understand that, unlike fixed deposits and small savings schemes, debt mutual funds are not risk free and do not assure returns. I was at a wedding couple of years back and in it was a small gathering of people who were discussing about markets and investments. A well regarded chartered accountant said in this small gathering that, debt funds were risky as equity funds. Since he was more senior to me in years, I took him aside and told him that, he made either an uninformed or a casual statement, because the reality is very different. For the benefit of our readers, let me refer you to our Mutual Fund Category Returns tool in our Research Section. In this tool, we have the average, maximum, minimum and median returns of all mutual funds in different categories. Select a period of 1 year or more, and you will see that, even the worst performing debt fund (across all debt fund categories) did not give negative returns; the same cannot be said about equity funds.
   
   If you understand the risk return characteristics of debt funds and invest accordingly, then your return on investment can be substantially higher compared to assured return fixed income investments. Furthermore, debt funds are more tax efficient than almost all other fixed income investments, especially for investors in the highest tax bracket. For investment horizon exceeding 36 months, capital gains from debt funds are taxed at 20% after allowing for indexation benefit, whereas most other fixed income investments income are taxed at the income tax rate of the investor.



5. Ignoring the impact of taxes:

   My cousin bought a new car last to last Diwali. He told me that for the down payment of the car loan, he redeemed his midcap equity mutual fund investment made earlier that year and made a handsome profit even after paying exit load. I asked him whether he factored in 15% short term capital gains tax for his income tax returns for that financial year. If he had waited for 3 – 4 months more, he could have avoided paying the short term capital gains tax.
   
   An ex-colleague, last year, wanted to invest his funds in an arbitrage fund for a few months. He wanted to know, which option (growth, dividend or dividend re-investment) is the most efficient one for him. This ex-colleague is more financially savvy than my cousin (who bought the car), while short term capital gains in equity funds is taxed at 15%, dividends are tax free. By investing in dividend re-investment option in arbitrage funds, my friend saved a lot on taxes, which my cousin did not. You should always factor the effect of taxes in your investment decision, because it can make a big difference to your returns.
   
   Mutual funds do not deduct tax at source unlike bank fixed deposits. However, this does not release you from your obligation to disclose income from your investment in your income tax returns and pay the necessary taxes. If you fail to disclose the income in your income tax returns and pay the necessary tax, then the consequences can be severe.
   
   Further, advance tax is liable to be paid on all income including capital gains. If capital gains tax arises before the due date of advance tax, you should compute the tax payable and pay advance tax otherwise you will be liable to pay an interest of 1% on deferred taxes. You can ask your financial advisor to prepare a capital gains tax statement for you. Else, you can download the realised capital gain statement on your mutual fund investments from the Registrar’s website, by registering your email address.



6. Investing without a financial plan:

   A recurring theme in our blog has been that, mutual fund investments should be based on financial goals. However, a vast majority of retail investors in India do not have any financial plan, formal or informal. They invest mostly on an ad-hoc basis, based on advice of family members, relatives, friends and neighbourhood agents. As a result, they end up with wrong financial priorities and are often not disciplined enough about investing. A common mistake is to prioritize short term objectives over long term objectives.
   
   Investors without a well structured financial plan may end falling short of their financial goals.
   
   At different stages of life, different goals seem relatively more important to us. For example, if you are in your thirties and do not own a house, buying a house may seem to be a very important goal. Retirement, which is twenty five or thirty years away may not be a very important goal. When you have very young children, saving for their college higher education may not be a priority.
   
   However, over your entire saving and investing lifecycle, all the above goals are very important. We often get queries and comments from our readers, asking about the best midcap fund or large cap fund. I think it is the wrong question to ask, unless you have figured out an answer to the best financial plan for your goals. Your financial plan will help you to be ready for each of the financial steps in your life. If you do not have a financial plan you are likely to make many mistakes that we discussed in this blog. Financial planning in essence is identifying different goals and can help you meet your short term, medium term and long term financial objectives, and developing a plan to meet all these objectives.

Conclusion

In this two part post, we have discussed some common mistakes which investors should avoid these when investing in mutual funds. Whether you are investing directly or through a financial advisor, investors should remember that, the onus is ultimately upon them, because it is their own money. A good financial advisor may provide you guidance on how to best manage your investments, but at the end of the day, you have to make the decision. We in Advisorkhoj believe that, if you educate yourself on financial planning and investments, particularly mutual funds, you will be able to make better financial decisions.

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