Do not make these blunders when investing in mutual funds

Blunder 1: Buying low NAV funds in hope of outperformance

Most investors believe that choosing a mutual fund that has a low NAV can give more return compared to a mutual fund that has a higher NAV. They think that by investing in a fund with a low NAV they will get more units, resulting in more profits when redeeming the fund. Now let’s look at the calculations below:

Mutual fund AMutual fund B
Amount invested50,00050,000
NAV when buying101,000
Units allotted50,000/10 = 500050,000/1000 = 50
Let’s assume that both mutual funds grow @ 20% in one year
NAV when selling111,100
Amount received after selling11*5,000 = 55,0001,100*50 = 55,000

As you can see that the amount received in both cases after selling is the same and both have generated the same profit of 5,000. Now that you have seen that NAV doesn’t affect the performance of the mutual fund, let’s understand how NAV is calculated.

Let’s assume the mutual fund has an AUM (asset under management) of 1000 crore, which consists of both investment and cash component. Mutual funds don invest all the amount they have pooled, they always have some cash handy so they don’t have to sell stock holdings when redemption requests from fund holders are received. Suppose this mutual fund has liabilities of 50 crores. Now its NAV will be calculated as below:

AUM1,000 Crore
Liabilities50 Crore
NAV{(AUM-Liabilities)/Total units} – Expense ratio
Let’s say this fund has 10 crore units
NAV1000-5010 = 95 Rs. – Expense ratio

When it comes to mutual funds, the expense ratio displayed by the asset management company (AMC) is just a yearly percentage. For easy calculations, let’s set aside this expense ratio and imagine the net asset value (NAV) is 95 Rupees. The mutual fund company has the power to determine the number of units it wants to keep in its fund. The more units issued, the lower the NAV, and vice versa.

So, it’s clear that the returns of mutual funds don’t depend on the NAV of the fund, but rather on the skill and strategy of the fund manager. They play a crucial role in deciding where and how to invest, making their abilities a deciding factor in determining the return on investment.

Blunder 2: Investing in sectoral funds

Sectors in the stock market behave in a cyclical manner and so do the sectoral mutual funds. When they go up, they go up quickly; when they come down, they come down quickly. Since these funds have most stocks from the same sectors, they do not offer true portfolio diversification.

Investing in sectoral funds or thematic funds unnecessarily complicates mutual fund investing. It is best for retail investors to keep their mutual fund portfolio strategy simple so that they can stick with it for the long term.

One example of a simple strategy will be to buy one flexi cap fund which gives you exposure to greater investment choices and diversification possibilities. If you want to reduce risk further in your portfolio, you can buy one large-cap fund.

Blunder 3: Buying too many mutual funds

Buying too many mutual funds in the portfolio is a grave mistake. Many retail investors have more than 10 mutual funds in their portfolios. Having more than 3-4 mutual funds in your portfolio is not advisable.

Due to shiny object syndrome retail investors often chase “hot” mutual funds, due to this after some time they end up with a lot of funds in their portfolio. After some time, they will forget why they bought the fund in the first place, making it difficult to manage the portfolio. 

Investing in too many mutual funds overly diversifies your investment and such portfolios often fail to give better returns than the index fund. One simple way to eliminate this problem is to check for mutual fund portfolio overlap.

There are numerous websites, where you can check the overlap across funds in your portfolio. If the overlap is more than 30%, you should consider decluttering your portfolio.

Blunder 4: investing in low-expense ratio mutual funds

Often retail investors give too much importance to the expense ratio of the fund when deciding which fund to invest in. although it is true that among similar types of mutual funds, the one having a lower expense ratio will generate a higher return, but the expense ratio alone should not be the deciding factor when choosing the mutual fund from different categories. 

Now let’s head back to the formula of NAV.

 NAV is calculated as =  {(AUM-Liabilities)/Total units} – Expense ratio. The expense ratio is deducted already in the calculation of NAV, which means that the graph of the fund that we see on AMC’s website is NAV to NAV including the expense ratio. 

A fund with a slightly higher expense ratio and very good return is always preferable to a fund with a lower expense ratio and average performance given that the fund manager has a proven long track record of generating good returns.

Blunder 5: Selling mutual funds frequently

In the history of every mutual fund there always comes a time when the fund is not able to outperform the market. At such times, most retail investors sell the fund and buy a new fund that has given outperforming returns in the last one year. By doing this they inadvertently hurt the performance of their portfolio. 

When you sell and buy too frequently, you are going to incur either short-term capital gain tax or long-term capital gain tax. The more often you going to sell the funds the more your tax liability is. This reduces your capital for investment to buy new funds. 

A much better approach is to invest in funds after a good research and keep holding it till there are no strong fundamental reasons to sell or switch. 

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