Equity as an asset class has consistently outperformed fixed investment and other asset classes over the long term by a wide margin. This has attracted an increasing number of fresh retail investors into equity markets through equity mutual funds. While increased retail participation augers well for the financial inclusion and overall growth of the economy, fresh investors are typically prone to certain myths and investment mistakes.
Here is a list of six common investing mistakes that fresh mutual fund investors usually make:
Comparing NAVs to select mutual funds
Many investors suffer from a popular misconception that mutual funds with lower NAV are cheaper. Some distributors promote New Fund Offers as their units are issued at a face value of Rs 10. The NAV of a fund can be low or high due to various reasons. As the funds’ NAV is based on the underlying asset’s market price, the NAV of a well-managed fund can grow better than other funds. Likewise, a relatively newer fund can have lower NAV in comparison to older funds as it had shorter time to grow. Therefore, avoid using NAVs for fund comparison and use a funds’ past performance and its future prospects of outperforming their benchmark indices and peer funds as a selection parameter.
Investing for dividend
Many mutual fund investors consider mutual dividends as some form of a windfall income. Some distributors also try to take advantage of this by pushing mutual fund schemes that have just declared dividend. However, what those investors fail to understand is that the dividend declared is paid out of fund’s own AUM, which means the investors’ own money. This is why the NAV of a fund gets reduced by the dividend amount. Moreover, the dividend is calculated on the basis of the face value of the fund, not on its NAV. For instance, if a fund with NAV of Rs50 declares 50 percent dividend, the dividend amount will be Rs5 (50 percent of Rs10, its face value), and the NAV will go down to Rs45 after the dividend record date.
Opting for dividend option also lacks in tax efficiency. When mutual fund pays dividend, the investors receive tax free dividend in hand. However, the fund has to pay 10 percent dividend distribution tax (DDT) on the dividends disseminated. This is realised from the fund’s AUM, thereby impacting investor’s returns. Hence, investors should rather opt for growth options and benefit from the power of compounding.
Stopping SIPs during falling market
Volatility is an inherent characteristic of equity markets. However, retail investors witnessing this situation for the first time often tend to discontinue with their SIP investments. However, investors should continue with their SIPs during bearish market conditions as that will buy them more units at lower cost owing to lower valuations. This will reduce the average investment cost, thereby generating higher returns over the long term.
Ignoring investment objectives during fund selection
Mutual funds state their investment objectives, investment mandate and asset allocation strategy in their various investor communication materials, such as product leaflets, e-mailers, fact sheet, scheme information document (SID), etc. With their help, investors can figure out whether a certain fund is compatible with their risk appetite, financial goals and time horizon. Ignoring these information will leave them with a wrong fund for their risk appetite and financial goals.
Expecting unrealistic returns
Bull market conditions attract most of the fresh investors in equity funds. Exceptionally high returns during bull markets lead many to invest their investible surplus, even those meant for short term goals, into equities. As a result, as and when markets correct, they either liquidate their investments in panic or to meet their short-term requirements. Hence, choose your equity mutual funds based on your risk appetite and time horizon of your financial goals and not based on their recent past performance.
Not diversifying enough
Many fresh investors invest their entire investible surplus in just one scheme, sector or theme that delivered excellent returns in the near past. However, doing so concentrates the market risk to just one sector/theme or fund management team. If your selected sector/theme goes through an adverse market condition or the fund management of your scheme takes wrong investment calls, your investments might underperform the broader market for a long period of time. Thus, instead of putting all the eggs in one basket, diversify your investments across multiple diversified equity funds to reduce your fund management and concentration risk. If any particular fund underperforms, the other funds in your portfolio will compensate for its underperformance. Opt for a sectoral or thematic fund only if you have a good understanding of the underlying theme/sector, both in terms of future potential as well as the risks associated with it.
Naveen Kukreja is CEO and Co-founder of Paisabazaar.com.