Why do we buy mutual funds? The question is less dangerous to ask, but more difficult to answer than why we eat Chlormint! There are two kinds of mental processes that lead us to buy something, anything. In one, we have a particular need for a product and the desire to satisfy that want is the driver. In the other, we see something and then invent a desire for it in order to justify the purchase. Most decisions are a combination of the two, but investment decisions should not be so.
Here’s how it normally works. Let’s say you feel the need to own a television set because you’d like to watch all the wonderfully entertaining, informative and tasteful programming that are now available. (I know what you’re thinking, but bear with me). Once you’ve decided that you do need a TV, the desire-creators take over. 32 inches? 42 is better. 56 even more. HD is a must, and it must be full HD. And don’t forget in-plane switching.
Or, you could start at a different point. You already have a TV and don’t find the programming entertaining, informative or even tasteful. However, the ads make you feel that it’s time to buy a new TV that can do tricks that the old one can’t and you’re willing to junk the old one and blow some cash on a new one that has HD, IPS, or whatever.
Unfortunately, the selling and buying of mutual funds (and even other investment products) follows the second model rather than the first one. Ideally, the starting point would be that you realise that you need to invest to generate the money to fulfill some specific needs. Thereafter, you would choose the type of fund, or funds, that most fit your needs. And then you’d go ahead and invest in the ones you have chosen.
For example, you need to save up for a big expense that’s perhaps a decade in the future. The money that you’ll save for this expense is not a big part of your net worth and the period is long so investing in an all-equity fund is the best way to go. Having decided this, you should look at the track record of all diversified equity funds and choose a small number, perhaps two or three that have registered good long-term performances. Then, you should start investing gradually, allocating an equal amount to all of them.
Now, compare this ideal method to the more prevalent ‘consumer goods’ style of choosing a mutual fund. You see an ad (or otherwise come to know about) for a fund with a particular set of features. Say it’s an infrastructure fund or an ‘economic reforms’ fund, or one which invests in turnaround cases, or something else which you didn’t know about. You see a commercial or listen to a convincing story about how this or that feature-set, or theme, makes sense. You get worried that your investments don’t have that feature. And so you believe the story and invest in the fund.
The difference between the two types of decision-making couldn’t be more stark. One starts with real needs and the other starts with an artificial need that serves someone else’s business purpose only. However, when you pause and think of your investments in a careful, step-by-step way, then it isn’t difficult to make the right choice the right way.