Dhirendra, many investors prefer investing in new funds because of their lower price per unit or the NAV. However, you advise against it. What is wrong with that?
Dhirendra: Yes, this is one of the biggest myths and it is very hard to demystify it. Because in all walks of life, buying something at a lower price is believed to be good. However, this does not hold true for mutual funds. It is more of a convention that a new fund starts with a face value of Rs 10.
Intermediaries often use this technique to easily sell the fund. They give you a comparison that it is available at a price of Rs 10, while the NAVs of other funds available in the market have already touched Rs 1,000. It is easy for anyone to believe that a thing available for Rs. 1,000 is more expensive than the one available for Rs. 10. However, it does not matter in the case of mutual funds. What actually matters is how much the fund appreciates.
A fund is nothing but a derivation of all that it owns. If the underlying investment goes up by 25 per cent, your 10 rupees would become 12.50 rupees and 1,000 would become Rs 1,250.
Also, it is not that if a fund's NAV has already reached Rs 1,000, it can't go up any further. NAVs are a function of age and how well the underlying of fund is performing.
Myth #1 debunked: The level of NAV does not matter in mutual funds.
The next one I would like to discuss is that many investors chase near-term performance and switch funds based on their returns, say, in the past one year. How good or bad is it?
Dhirendra: It is not bad to switch to a superior alternative but the problem arises when you chase recent performance and make a switch based on three-month, six-month or one-year returns. Time could be misleading.
Understandably, when you see something going up by 40% over the last three months, you decide to ride on it. But normally, it is a big disadvantage. If something has done exceptionally well within a brief period of time, it may not go up that sharply in the immediate future. There is always a reversion. And when it collapses, it will be a great disappointment.
The only methodical way is to align your investment with your risk appetite and horizon. More importantly, stick to your plan for a reasonable period of three to five years.
If you keep hopping from one fund to another to get higher returns, this may not come true always and will lead to disappointment. Also, you have to bear the disadvantage of paying capital gains tax while shifting from one fund to another. It would also be a loss on compounding. So, just choose your fund based on your risk appetite, time horizon and past record and then, stick to it. You won't have to pay any capital gains tax until you sell it.
Myth #2 debunked: Don't be hyperactive. Instead, align your fund selection with your risk appetite and investment horizon before looking at the returns. Stick to your plan.
Let's move on to the third myth, which is about dividend plans. People feel that dividend is an additional income. How would you like to elaborate on that?
Dhirendra: Dividends are preferred by many investors, as they perceive that the company has made profits and that their investments are doing well. When a company makes profits, it retains a part of it and distributes the rest as dividends. So, people consider them as a well-performing investment. When they invest in a house or real estate, they get rent as additional income. Similarly, when you put money in any other investment, you get some sort of interest or income. So, they think dividends as the additional income. However, in mutual funds, dividends are nothing but withdrawing a part of your own money and depriving it from the benefit of compounding.
Suppose you invest 10 lakh rupees in a mutual fund and it becomes 12 lakh in a year's time. They will give you Rs 1 lakh as dividend and reduce the NAV of your investment from 12 lakh to 11 lakh. So, it is like withdrawing a part of your accumulated profit. You also lose on the compounding in the long term, as less money is put to work subsequently.
Even if you need regular income, regular withdrawals from a growth option is a much better alternative. Dividends are liable to Dividend Distribution Tax (DDT). In the case of debt funds, it is around 29% and in the case of equity funds, it is 10%. Taking the previous example ahead, if it is an equity fund, only 90,000 rupees would be credited in your bank account. Around 10,000 would go towards DDT. So, dividend plans anyway don't make sense any longer.
Myth #3: Dividend is not additional income. It is like withdrawing a part of your money.
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This article was originally published on June 03, 2019.
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