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Summary: The road to riches is paved with traps that can break your confidence. In this article, we highlight five such mutual fund traps that you can avoid. Our goal is to ensure you can build wealth in an effective manner.
In school, teachers overlooked the brilliance of Albert Einstein. In fact, one of them told him, “You’ll amount to nothing.”
Luckily, Einstein didn’t let those words trap him into a spiral of doubt. Instead, he went on to transform science and spark technologies that shape our lives even today.
Mutual fund investing also has such traps that can break the confidence of an investor.
However, the real difference between a seasoned and a new investor lies in how they adapt and move forward.
This article helps you recognise five such traps. And by making a simple change in your approach, you can turn these potential setbacks into stepping stones for long-term success.
Starting late
When we are in our 20s, investing is hard. Our income can’t seem to keep up with the onslaught of financial responsibilities. So, we put off our SIP for another day.
However, there’s a hidden cost to every form of procrastination. Except this is much higher in the case of investing.
Let’s take the case of two colleagues: Rohit and Ananya.
Rohit invests regularly with a monthly SIP of Rs 15,000 in funds of his choice. He has been disciplined with his investments, putting money aside for the last five years – like clockwork.
Ananya, on the other hand, started investing 15 years ago. And her SIP is a significantly smaller sum of Rs 5,000.
If both earn 12 per cent per annum and check their portfolio today, who do you think would come out on top?
Surprisingly, Ananya will be far ahead despite the smaller sum. She’ll have a substantial Rs 23.8 lakh.
Rohit will be left with a little over Rs 12 lakh.
This is the power of time. If you start with even a small sum, you can build a fortune provided you start quickly.
Suggested read: This ₹5,000 SIP grew twice as big as ₹15,000 SIP. Here's how
Timing the market
There are two ways of investing in a mutual fund: an SIP or a lumpsum. One allows you to invest in a mutual fund at regular intervals. And the other one requires you to time your investment just right.
While one approach relies on being disciplined with your investments, the other one can only work if you can predict market movements.
But let’s face it. Who has the crystal ball for market movements? Hence, this makes timing the market right nearly impossible.
Another issue is that a serious drop, like 10 per cent, is hard to come by. That means if you were to wait for every drop to invest, you’d barely build a corpus that way. We’ve broken down the numbers in this detailed article on why SIPs edge out over lumpsums. It helps you understand why timing the market is an exercise in futility.
Suggested read: The futility of market timing
Fear and greed
When our money is on the line, the most irrational tendencies become the norm.
Thus, even geniuses can get swept by the herd. And the herd is driven by either fear or greed. These extremities can only be recognised in hindsight.
To observe how these tendencies pan out, let’s look at the two key phases of the market: the bull and bear markets.
In a bull market, it feels like you’re investing on steroids. Any fund you buy, you just can’t go wrong. So, you pile on more and more funds from different corners of the market, having a minuscule allocation to each. You give in to the excitement – the greed kicks in.
However, then comes the bear market. Those investments now begin showing their true worth. As with any steroid, the gains are temporary. And so, you lose a lot of money overnight. That’s when the panic kicks in and you sell pretty much everything.
A similar situation is taking place with people who have invested in sectoral and thematic funds. They were lured by the remarkable performance of the last few years. Thus, every sectoral and thematic NFO seemed like the next best thing since sliced bread.
After a while, people weren’t investors any longer – they were now collectors. Naturally, they piled up on fund after fund.
The real issue with these funds is that once a sector or theme goes out of favour, the funds hit a slump. In essence, they are kings during peacetime and paupers during wartime.
However, as the term “herd mentality” suggests, it is rare to find anyone who isn’t affected by it. Instead, to protect yourself, you have to exercise a degree of rationality in your investments, even if it means going against the crowd.
Make sure you follow a framework for choosing your mutual funds. A framework will ensure that you don’t give in to knee-jerk reactions whenever the market swings to either side – bull or bear.
Suggested read: Sectoral delusions
Understanding risk tolerance
There’s a large portion of the population that believes that going all in on equity is a smart tactic. However, the constant ups and downs of the market can make anyone’s stomach churn. This makes it essential to have guardrails on your portfolio.
These guardrails are known as an asset allocation.
While it might sound like a complex term, it is actually just the proportion of equity to debt in your portfolio. And the mechanics of this strategy are simple. The equity portion zooms up during rising markets. Whereas, in falling markets, the debt portion protects the portfolio.
Throughout your investment journey, you should always have a smart asset allocation. And over time, your portfolio should shift towards debt. This ensures that as you near your goals, your wealth remains conserved and protected from market downturns.
Our advice would be to choose aggressive hybrid funds for this purpose. After all, it can be a challenge to maintain your own asset allocation. The constant buying and selling during different market conditions racks up a hefty tax bill.
Instead, these funds allow you to maintain a desired asset allocation without having to pay taxes on the transactions. This is because these transactions take place on a fund-house level.
Lastly, these funds invest at least 65 per cent in equity and equity-related instruments. This gives you two benefits: 1) you get inflation-beating returns; 2) you get equity-like tax treatment. All in all, these funds are an elegant solution to the investment needs of most beginners.
Suggested read: Mutual fund taxation: Here’s how it works
Know what you own
Many new investors chase what worked yesterday. They see high returns, claim to be aggressive, and pile in. Veterans, on the other hand, pick investments that truly suit them – even if it means being labelled conservative.
Take the small-cap rally. Past returns made these funds look irresistible, and plenty of new investors jumped in expecting the same fireworks ahead. But when volatility struck, they panicked and dumped their holdings. They weren’t long-term investors; they were simply chasing yesterday’s winners.
Seasoned investors behaved differently. They entered small-cap funds knowing full well that past rallies don’t guarantee future gains, and that turbulence is part of the package. So when markets turned, they weren’t caught off guard.
That’s the key. A star performer of the last few years may not be the right fit for you. Unless you understand the risks, buying into the hottest category is just buying into yesterday’s story.
Suggested read: I invested Rs 3 lakh in small-cap funds last year. Big mistake?
Want to sidestep these five traps?
These are investment mistakes that any person is prone to making. This is because it is tough to go against the behaviour of the herd. Instead, you should seek the guidance of experts who have decades of experience in mutual fund investing.
Value Research Fund Advisor brings you such veteran advice that keeps you on track with your investments. You’ll get personalised recommendations that you can have complete faith in. And no matter how the crowd behaves, you’ll make lasting wealth. After all, time in the market is crucial, and no investor can afford to lose their wealth, making sub-optimal decisions.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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