With the stock market on the upswing and investors looking for newer investment options after rate cuts post demonetization, mutual funds have become one of the most popular investment choices. The advent of online investment platforms has encouraged many mutual fund investors to manage their own investments.
However, it is critical that investors are aware of some basic mistakes that they should stay clear of. Here are some of the most common ones that you should avoid:
Buying mutual funds because of their low NAVs
Investment advisors often pitch new fund offers (NFOs) citing low NAV (Net Asset Value). They equate the concept of NAV with share prices to convince the investors that NFOs or other low NAV funds are cheaper. However, this is not true. NAV is arrived at by dividing the total value of the securities held by a fund with the total number of units issued to its investors. The NAV of a fund will depend on how far the prices of the fund's underlying assets have increased. So, a relatively new fund will always have low NAV while older funds will have higher NAV. Similarly, the NAV of a well-performing fund will always be higher than an average or a poor performing fund issued on the same date.
Instead of NAV, what matters is the fund's past performance and the possibility of continuing such performance in the future. Let's assume that you have two funds, Fund X and Fund Y, to choose from. While Fund X with NAV of Rs 15 has delivered an annualized return of 12%, Fund Y with NAV of Rs 55 generated higher return of 20%. You should always prefer Fund Y as it has delivered higher returns in the past. Thus, never consider a fund's NAV for comparing mutual funds.
Investing in mutual funds to earn a dividend
Just like NAVs, some advisors misinterpret mutual fund dividends as some sort of a windfall. As soon as a mutual fund declares dividend, some advisors will entice their customers to buy the dividend option of that scheme for booking that 'quick return'. However, what those advisors never disclose is that mutual funds pay dividend from your own investment only. As soon a mutual fund pays dividend, the NAV of that fund is reduced by dividend amount.
For example, if a scheme with an NAV of Rs 20 declares a 30% dividend, its NAV will reduce by Rs 3 (30% of face value Rs 10) on the dividend record date. Thus, the mutual fund is only paying back your own money. Instead, of opting for the dividend option, always go for the growth option to benefit from the power of compounding.
Overlooking the investment objectives
The investment objective of a mutual fund states how it proposes to manage your investment. It mentions the type of stocks and other securities or the sectors and themes that the scheme will invest in. It also states the proportion of various asset classes to be held by it. Ignoring the investment objective may leave you with a wrong fund for your financial goals.
Unrealistic expectations from equity mutual funds
Most first-time mutual fund investors enter equity markets during the bull-phase. Exceptional returns generated by the funds during this phase lead them to invest with unrealistic expectations about returns. As a result, many compromise their liquidity by channeling their entire surplus into equity funds. Others invest in equity fund to make quick returns for their short-term goals. However, returns generated during the bull phase are unsustainable. As and when the markets start to correct, such investors start to liquidate their mutual fund investments fearing further losses or to meet their short-term financial requirements.
Instead, invest in mutual funds according to your time horizon of your financial goals. As equities can be very volatile in the short-term, invest in income accrual funds for investment goals maturing within 3 years. As equities beat other asset classes over the long run, invest in equity mutual funds for financial goals maturing after three years.
Not diversifying enough
Often, investors invest their entire surplus in just one mutual fund. Similarly, many investors over-expose themselves to a particular sector or theme, which have generated outstanding returns in the last few months or a year. These concentrate their investment risk with just one fund management team or a particular sector. Instead of putting all your eggs in one basket, reduce your investment and fund management risk by investing in schemes of various fund houses. So that, even if one scheme underperforms, your investments in other schemes is likely to save the day for you by delivering higher returns.
(Naveen Kukreja is the CEO & Co-founder of Paisabazaar.com)