Oct 31, 2008

The Smart Way to Mutual Fund Investing: 10 Time-Tested Principles

HOW much time do you devote to investing? Now, tell me how much time and effort do you devote while making a spending decision - whether you’re buying clothes, a piece of furniture or anything else? Why can’t you apply the same consumer mindset while making investment decisions?

Put simply, give your investment decision making the due importance it deserves. Also, let your investing decisions be guided by your needs rather than be driven by your emotions or the outside forces like current market behaviour.

Here is a list of some fundamental rules you, as an investor, should follow while designing a mutual fund portfolio:

1. Knowledge is Power
Get informed. It’s a universal truth that knowledge is power. Staying informed is extremely important in today’s investing world.

2. Look before you Leap
Investing money whether directly in the market or through mutual funds has its fair share of risks which you as an investor must understand. In order to reduce the probability of losing your hard earned money, you should take a cautious approach and tread the investing path carefully.

3. Old is gold
It is always preferable to invest in existing schemes rather than NFOs. Why? Although past achievements are not indicators of future performance, they are good starting point. Suppose a particular fund is continuously beating its benchmark for last 3 or 5 year. It does not guarantee that it will continue to do so in future as well. It might or might not. However, the probability remains high.

4. Good wine needs no bush
Be wary of misleading schemes names. In most of the cases, NFO’s are just old wine in a new bottle with fancy tags attached to them. They are simply marketing gimmicks to attract new customers and to take out more money from the wallet of existing customers.

Thus, never invest in a new scheme unless it has something new and better to offer.

5. Slow & steady wins the race
It is always prudent to invest in smaller amounts at regular intervals either yourself or through “systematic investment plans” (SIPs) rather than making a one time big investment.

Regular investing in small amounts help bring discipline into savings and investment; and helps in rupee cost averaging.

6. Don’t put all your eggs in one basket
This old saying is particularly relevant when it comes to investing. Although mutual funds give you built-in diversification but still you need to invest in 4-6 different schemes.

Diversification helps reduce risks by spreading your investments among various asset classes and different sectors and securities within an asset class. By having exposure to large number, your portfolio performance is not dependent upon a single asset class, industry or a company. It helps reduce your portfolio risks and improve returns over time.


However, be careful while diversifying so as not to duplicate funds having the similar stocks which will negate the very purpose of diversification.

7. Don’t try to have a separate basket for each egg
Diversify but at the same time don’t over-diversify. The number and the type of funds you invest in should neither be too few nor too many. Having too many funds defeats the very purpose of diversification.

In case you are having too many funds, there’s likely to be some duplication of companies and sectors. To avoid duplication, it is better to represent a fund category with just one fund.

Furthermore, the basic purpose of active investing as opposed to passive investing is to beat the market returns. But by having too many funds, say, 15-20 funds in your portfolio, you will be effectively holding a market portfolio by paying a high cost. The best and the cheapest way to hold the market portfolio is to go for index funds/ETFs.

Understand that while it is ok to hold 15-20 stocks for diversification but holding 15-20 funds amounts to excessive diversification. Thus, don’t apply the traditional wisdom of stock diversification to mutual fund diversification. Restrict yourself to not more than 5-6 funds.

8. A rolling stone gathers no moss
Stay invested. Don’t do frequent churning. From time to time you keep on receiving unsolicited advice from your mutual fund distributor to shift money from one scheme to other by recommending ‘booking profits’ and investing in other scheme. Remember that frequent churning of your portfolio only helps the agent and not you. Frequent churning of your portfolio is also painful from tax and cost point of view.

You should stay invested unless the fund performance has deteriorated considerably in the recent past. And if you decide to churn always keep in mind the cost of churning (entry/exit loads and the capital gains).

9. One swallow does not make a summer
Whether or not you ask for rebate from mutual fund distributor is your own decision. I am not going to comment on that. But never base your investment decision solely on rebate offering. The question of rebate should only arise after you are convinced about where to invest.

10. Don’t go on a wild goose chase
Never chase performance. Short-term results may not tell the whole story. While evaluating performance, look beyond the recent past because impressive results in one particular year can distort/skew the fund compounded returns (CAGR) and create a mirage of outperformance. In addition to the CAGR, always look at the annual returns because CAGR can obscure the true consistent performance.

Furthermore, in most of the cases, exceptional short term returns reflects the good performance of markets/asset class rather than managerial skill. By the time you jump into the bandwagon, it is too late. You are likely to make a buy at nearer to the peak of the cycle and when the cycle turns you will be disappointed.

So don’t get carried away by the media hype or advisor’s tall claim and resist the urge to rush into investing in a top performing fund.

Related Posts:
1. Mutual Fund Investing: 6 Fallacies Demystified
2. Mutual Funds vs Direct Investing: How to Decide?

5 comments:

  1. Hi Mr. Fisher
    I've been reading yourt blog for the past couple of weeks and I should say that I've learnt a bit how to fish! About MFs especially. However, I'm sure there is much more to learn. So a few questions :-
    - What is the main difference between Long Term and Short Term Floating Rate Funds?
    - Can you give a more detailed comparison between Gold ETFs and World Gold Funds. Actually I'm keen on continuing investing in MFs online (using HDFC MF online account) but I'm not too keen in getting a DEMAT account just yet.


    Regards,
    M Hari

    ReplyDelete
  2. Hari: Thanks for the appreciation.

    Just wait for sometime. I’ll be explaining the difference between long term and short term floating rate funds in my detailed write ups on debt funds.

    Regarding gold ETFs and world gold funds, you can read the post, ‘How to Invest in Gold ETFs’ & ‘5 Different Ways to Invest in Gold’. Still if you can’t make out the difference between the two, let me know the kind of detailed comparison you’re looking for.

    ReplyDelete
  3. Hi Mr.Fisher
    Thanks the write up on "5 different ways to invest in Gold" was quite informative especially for a lay man like me.

    Your article on NCD was a revelation (am understating here). How does one get to know atleast a bit in advance about when (date etc.) NCDs will be issued? Have been trawling the net for some info looks like am searching the wrong places.

    Hope I can write a post on multiple issues at one place or would you prefer that I do it separately?

    regards,
    Hari

    ReplyDelete
  4. Hari: A company announces forthcoming issue of NCDs through a press release which is published in newspapers.

    Sorry, i could not understand your second question.

    ReplyDelete
  5. hello,

    i am a new investor and just learning to invest in mutual fund. can u ps help me to find some good rated mutal fund (equity only) for long time basis.

    thanks
    soham

    ReplyDelete

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