10 common mutual fund investing mistakes that you should avoid

The quarter ending September 30, 2015 was the fourth successive record quarter on quarter retail mutual fund volume growth. While this is an indicator of growing awareness of mutual funds among retail investors in India, if we look at the population base of India and the penetration of mutual funds, we are still way off, from where we should be. Mutual funds are ideal investment options for retail investors to help them in meeting a variety of financial goals. While completely ignoring mutual funds is the biggest mistake which a vast majority of retail investors make, investors who are aware of and invest in mutual funds also make a number of mistakes which prevents them from getting the optimal results.

In this blog, we will discuss 10 common investing mistakes, which mutual fund investors should avoid

1. Waiting for market to correct before investing:

   Greed and fear psychology is at play for investors who wait for market to correct before investing. In my experience, investors who follow stock markets are more likely to exhibit this trait as opposed to investors who do not follow markets. Investors should understand that individual stocks and mutual funds are different investment instruments. A mutual fund comprises of a portfolio of stocks. So while an individual stock in a fund portfolio may be overvalued there will also be stocks which will be undervalued. Diversification of individual company risk, also known as unsystematic risk, is the fundamental concept of a mutual fund. The strategy to wait for market to correct can theoretically work if you believe that the market itself is overvalued. However, you should understand that it is extremely difficult, if not practically impossible, to correctly call a market bottom. Many investors who exited their mutual fund investment in 2008 ignored calls from financial advisors in 2010 or even 2011, thinking the market will correct further. In less than 24 months the market was 40% higher. At that point of time, some of these investors thought that the market has rallied at lot and it is not wise to invest at this level. In another 24 months the market rallied by a further 30%. Many investors invested at levels which were 50 – 60% higher than 2011 levels (Source: BSE Sensex data from November 2011 to November 2015). Just think of the opportunity lost. The point is equity markets are volatile. You should understand that the mutual funds are long term investments. You should invest based on your goals, irrespective of market levels.



2. Investing in large number of funds to diversify risks:

   This is another common mistake, which leads to sub-optimal performance. An individual mutual fund itself aims to diversify unsystematic risk, including stock specific risk and sector specific risk. Investing in a large number of funds does not necessarily lead to more risk diversification. To diversify the risk of potential underperformance of a fund, you can split your investments in a few funds. But if you invest in a large number of funds, there is a greater possibility that you will pick up underperformers, which will lead to sub-optimal portfolio returns. Also if you have a large number of funds in your portfolio it becomes more difficult. Having a large number of SIPs each of a small amount compounds the problem further. You have to ensure that you have sufficient balance in your bank account on each of the SIP auto debit dates. Further, if you have setup auto debits from multiple bank accounts, then you need to ensure each bank account has sufficient balance on the respective dates, which imply that you have to transfer funds to different bank accounts before each auto debit date. All these problems, for no real benefit! You should select a few good funds for your lump sum and SIPs, and track these investments on a regular basis.



3. Panicking and redeeming investments in bear market:

   You do not need to be another Warren Buffet to understand that you make money in equities by buying low and selling high. Unfortunately many retail investors do exactly the opposite. They invest in mutual funds when there is hype in the market and redeem in a bear market. It is natural for investors to be stressed in bear markets, when they see their portfolio diminishing in value every day. At the end of the day, it is your hard earned money. But by redeeming your investment when the market has crashed, you do not gain anything. At best you get the mental satisfaction that you did not lose more money if the market crashed further. On the other hand, if you invest based on goals then volatility and marked to market value of your portfolio hardly matters. Bull and bear phases are fundamental cycles of equity markets. After every bear market, there is a bull market and not only does the market recover from the lows, but the resultant rally most often takes the market to a new peak. This is especially true in a growing economy like India. You should be calm in market corrections and be disciplined about investing. In fact, if you are smart investor, you can tactically increase your allocation to equity if the market corrects more than 10% and earn exceptionally good returns.



4. Monitoring your portfolio performance daily:

   Equity markets are inherently volatile. On some days the market will be up and on other days the market will be down. Monitoring your portfolio on a daily basis serves no purpose except increasing your stress level. As discussed earlier, the marked to market value of your portfolio is of real significance. If the Sensex is lower by 2% in a day, it is quite likely that your equity portfolio value will also be lower. But it does not mean that you have made a poor investment or that you will not be able to meet your financial goals. As far as equity investments are concerned, you should have a long investment horizon and review the performance of the funds in your portfolio relative to their respective benchmarks, that too preferably in consultation with your financial advisor if you do not have the necessary investment expertise.



5. Never monitoring your portfolio performance:

   This is, based on my observation, actually a more common problem. Many investors simply do not take sufficient interest in their own investment. They invest based on the recommendation of their financial advisor and then do not care to see how their investment is doing. Some financial advisors are also to be blamed for not actively or even regularly reviewing the portfolio of their clients. A friend of mine recently showed her mutual fund portfolio to me. It was decent sized portfolio and I was surprised to see that more 90% of her investments were in infrastructure sector funds. She told me that she made most of these investments based on advisor’s recommendation in 2007 and some in 2009, but he never cared to monitor how her portfolio was doing. Naturally the portfolio returns were very poor. 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.



6. Booking profits in funds which gave good returns:

   This is one of the worst mistakes that you can make. 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. 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.



7. 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 balance in your savings bank to meet the expenditure. Sometimes mutual fund investors resort to redeeming their mutual fund units to meet such exigencies. 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. However, if you look at the opportunity cost of redeeming your equity mutual fund units, you will realize that it is much more than the lost interest and premature withdrawal penalty. As part of good financial planning discipline you should always set aside some emergency funds either in your savings bank account or in a liquid fund to meet any exigency. In a situation where your savings bank account 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.



8. 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, e.g. post office 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 short term debt funds. When interest rates are falling, investors can get better long term returns than fixed deposits by investing in long term debt funds. It is true that debt mutual funds are not entirely risk free and do not assure returns, but if you understand the risk return characteristics of debt funds and invest accordingly, then your return on investments 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 in most other fixed income investments, income are taxed at the income tax rate applicable to the investor.



9. Ignoring the impact of taxes:

   My cousin bought a new car last Diwali. He told me that for the down payment for 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. Equity Mutual funds do not deduct tax (in case of resident investors) 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 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. For CAMs serviced mutual fund investments, you can download your realized capital gains statement by registering your email address.



10. Investing without a financial plan:

    A recurring theme in this 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 seem to be a very important goal. If you have very young children, their college higher education is so far away that you may not really be concerned about it. However, over your entire saving and investing lifecycle, are any of these goals less important? No, all the goals are very important. 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 and help you meet your short term, medium term and long term financial objectives, and developing a plan to meet all these objectives.

Conclusion

Investors should avoid these common mistakes when investing in mutual funds. Mutual funds are long term investments. By selecting a set of suitable funds, and investing in them in a disciplined manner, investors can meet their short term, medium term and long term financial goals.

Disclaimer: