Mutual Funds – Mutual Mistakes

Money is a very strange thing. Human beings make rational decisions while dealing with most aspects of life, but make serious errors of judgment when it comes to dealing with money. This may be true at different stages – be it earning, protecting, budgeting, saving, spending, leveraging, investing or insuring. Completely rational investors take totally irrational decisions as part of a crowd.

Many a time, completely rational individuals commit simple mistakes while making investment decisions in common stocks. Those mistakes get compounded while investing in mutual funds. Fund managers, marketers as well as the markets themselves have their own ways of finding and exploiting human weaknesses. Here, I try to explain and explore the 10 most common mistakes which investors inevitably commit while investing in Mutual Funds (MFs).

Mistake 1: Imagining that low NAV is cheap

This is one of the silliest of mistakes while investing in MFs. Investors tend to believe that a fund with a lower Net Asset Value (NAV) is cheap as compared to one with a higher NAV. There is nothing further from the truth.

This blunder occurs because many investors neither understand nor appreciate the difference between price and value. A MF unit in itself has no value – it is NOT an asset like a house property, bond, equity stock, gold, etc. – but derives value from the underlying asset which it owns. The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units. Hence, a low NAV may not necessarily imply a cheap fund.

Mistake 2: Too costly or too cheap

This is not too far from the first mistake. A MF unit can’t be costly or cheap – it is not an asset in itself which can be costly or cheap. If the value of the underlying investment goes up, then the NAV will go up, and vice versa. For example, consider two funds – A and B – holding similar assets. Fund A is quoting at an NAV of Rs 10 and Fund B at Rs 50. In that case, a 20 per cent rise in the value of the portfolio will result in a commensurate 20 per cent increase in the value of the NAV of the funds – Rs 2 in the case of Fund A and Rs 10 in the case of Fund B. Hence, when investing in MFs, don’t look at the price of the NAV but rather at the underlying value derived from the portfolio of the fund.

Mistake 3: Buying MF NFO ‘at par’

Another derivative of the first two mistakes is investing in an MF NFO (New Fund Offer) simply because it is available at ‘par value’. Remember that an MF unit is not a scarce resource – an MF can create as many units as the inflows into the fund – it has to just print the units and send it to the investor – just like a government can, in theory, print currency notes infinitely. The same is not true for an equity share, because a company can’t just print its shares without diluting the holding of its assets.

Mistake 4: Fancy funds, fads and fantasies

Many new funds and schemes spring up during times of exuberance. Banking funds are launched when banking stocks have performed well, infrastructure funds when the infrastructure stocks are rising or IT funds when the technology boom is underway, and so on. Sector funds are simply smart tactics to collect money from gullible investors. No sector or theme continuously performs well over the long term.

Even worse, a sector fund is generally launched after the sector has performed well because the fund has to show good past performance to attract fresh investor money. And by applying the law of averages, it becomes likely that the sectors which have already performed well in the recent past will not perform so well in the foreseeable future. Hence, avoid falling prey to fund gimmicks to invest in sector or theme-based funds.

Mistake 5: Ignoring Index Funds

Ignoring a simple low cost index fund in favour of the high cost actively managed fund is another common mistake. You will be told by most people that equity investments are for experts, and if you don’t know how to pick your stocks, it makes sense to entrust your money to an expert fund manager. I agree that it is very difficult, if not impossible, to beat the stock market indices consistently over a longer period of time. If that were not the case, then for periods of a decade or more, why would approximately 75 per cent of all ‘actively managed’ stock funds underperform the passively constructed stock indices?

Most people have no reason to believe that they can pick winning stocks or time the markets, and their success at this would be the same as throwing darts at the financial pages. Here, I would like to quote Dr William Bernstein, who said that, “There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know where the market is headed. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know where the market is headed”. Nothing more succinctly explains the real world of professional investing and stock picking.
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Merton Miller, Nobel laureate and professor of Economics at the University of Chicago commented that, “If there are 10000 people looking at the stocks and trying to pick winners, one in 10000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful, but they’re really not”. Rex Sinquefield, co-author of Stocks, Bonds, Bills and Inflation, says, “We all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it”. Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices!

Let me further quote Jon Bogle, founder and retired CEO of the Vanguard Group: “Index funds eliminate the risks of individual stocks, market sectors, and manger selection. Only stock market risks remain”. In other words, when you invest in a passively managed index fund, all the risk relating to the fund manager, stock selection, market timing, individual sectors, etc. all go and the only risk which remains is the risk of the whole stock market. That is precisely the risk which you would like to expose yourself to when investing in equities.

Mistake 6: Selling winning funds and sticking to the losing ones

This is a grave mistake which people commit with MFs, equity stocks and other kind of investments. It is important to be realistic about investments that are performing badly, including MFs. Recognising the losers is hard, because it’s also an acknowledgement of your own mistake. But, it is important to accept and book losses at the right time, or else the future loss would be even higher.

Mistake 7: Fund churning

This is a common piece of advice, especially from MF distributors. Instead of churning your fund, it makes better sense to churn the MF distributor who gives you that advice! Distributors love the churning game – simply because it gives them extra commissions and fees. What it means for you is extra income tax, expenses and most probably a sub-optimal fund.

Mistake 8: Paying credence to recent past performance

Past performance is certainly important, but if you give too much importance to continuous performance by looking at daily NAVs, you invite unnecessary worries of selling a good fund and moving to a not-so-good fund, MF-churning advisors, income tax, higher commissions and other costs.

Mistake 9: The dividend temptation

When a fund declares dividends and trades cum-dividend, you may be advised by MF distributors and marketers to take this advantage to earn free dividends. But remember, there are no free lunches – particularly not in the world of investments and mutual funds. The dividend which a fund pays to an investor comes out of the corpus of the fund itself, and is hence, immediately reduced from the NAV of the fund. So, what sense does getting a dividend make when on one hand you receive the cash and on other hand your NAV falls by that much amount? I would say that you should not invest in a fund which has declared lofty dividends, because that is against your investment purpose – you are entrusting your money to the fund manager to manage it on your behalf and not to return it to you!

Mistake 10: Not understanding the types of funds

The primary purpose of MFs is to make your life simpler by investing your money on your behalf. However, many of them make your life difficult by making available a plethora of different categories and schemes. Hence, before biting the bullet, get acquainted with the category of fund you are investing in – equity, fixed income, balanced, commodity, international, and within them the various sub-sets like sector, theme, gilt, income, short-term, liquid, etc. The risk, expected return, income tax, expenses and required time horizon are vastly different in each of those categories. So don’t invest your money in a fund without actually knowing where and in which asset class it will deploy your money.

It will serve investors well to remember that simple logic works far better in the market rather than complex algorithms, theorems, valuations principles, discounted cash flow, etc. Also, there is no place better than the market to test your virtues – be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, performance under stress etc. The market has its own method of finding and exploiting human weaknesses. Investing is not about beating the market or anybody else, it’s simply about beating your own self. Articulate your investment goals, know your time horizon, recognise your risk appetite and understand your need for income and growth. Invest regularly although it may be in small lots, do your thinking and research, and after that, don’t panic just because the market went against you. Accept your mistakes and flaws and avoid the common pitfalls to become a successful MF investor.

Mehrab Irani is the General Manager – Investments with Tata Investment Corporation Limited. He is the author of a well-read book ‘10 Commandments for Financial Freedom’.

(The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Dalal Street Investment Journal.)