Mutual funds, autopilots and air crashes

"Pilot response led to AirAsia crash into Java Sea" ran a headline by CNN back in late 2015. A year into the crash, investigators had uncovered what had caused the crash of AirAsia QZ8501. The plane's Rudder Travel Limiter (RTL) had malfunctioned multiple times, which eventually led the autopilot to disengage. This forced pilots to steer the plane manually, resulting in miscommunication between the captain and co-pilot. Simply put, the crew was untrained to deal with such a situation.

Aviation safety statistics show that over the last two decades, more than 1,800 air passengers and crew lost their lives because pilots had lost control of fully functional aircraft. In fact, this has become an established category of air accidents. Earlier, till the 1970s or 80s, air accidents were generally due to aircraft malfunctions of some sort. As aircraft reliability and flying aids have improved, pilot errors are said to have come to the fore.

Suggested read: Understand and control

The US aviation regulator FAA has just concluded a five-year study on why this is happening. Its conclusion is that heavily automated aircraft have led to a situation where pilots are less used to flying manually than they earlier were. When something goes wrong, they tend to focus on getting the automation to handle it rather than managing the situation manually. The FAA says that pilots are less and less confident in their skills.

Of course, airline pilots are just one example of what is a general phenomenon. From maths students who can't function without a calculator to drivers who have no clue what happens inside a car when they press the accelerator or move the gearshift, more and more people understand less and less about the things they use. It's a far cry from the time when changing broken fan belts was a routine part of going on a journey in an Ambassador car.

Suggested read: The illusion of control in investing

I hope it's clear what all this has to do with your investments. Mutual funds are like an autopilot system for investments. You just set your destination, and the system takes you there-except when it doesn't. However, the problem is that far too many investors have no idea how the machinery works inside. You don't need to understand how funds work, not because you might have to manage a mutual fund one day but because an understanding will help you choose the right fund, create a suitable portfolio, and monitor it to ensure that nothing goes wrong.

I'll give you a simple example of a common mistake that is made by investors. They look at the recent returns of various funds and invest in the one that has the highest returns. Usually, investors who do this use the phrase 'X fund gives 20 per cent, but Y fund gives 25 per cent. The problem here is the word 'gives'. They think of equity mutual funds as they would have spoken of bank fixed deposits or some other assured-return type of investment. That past performance is not a promise of the same returns continuing in the future, too.

Similar is the case of investors who write to us accusingly about having dropped the rating of some fund. "I invested in this fund because Value Research gave it five stars but now you have taken away two of the stars," goes a typical complaint. However, ratings are based on a fund's own performance and can change if the performance changes. The worst problem is probably not understanding NAV and dividends. Even now, a majority of investors think that NAV is like stock price and fund dividends are like corporate dividends.

The answer to these problems is simple. A mutual fund may be like an autopilot, but you must learn what it does and how it does it. And Value Research's magazines and website are the best way to do so.

Also read: Real, practical asset allocation