Do you remember that Maruti ad some years ago in which a rich man who reminds one of Vijay Mallya is examining a luxury yacht he's planning to buy? He asks the salesman, "Kitna deti hai?" Mallya's luxury yacht days are long gone but the ad is still quite funny. It's also quite relevant to what I want to write about today so if you don't remember it, then go and watch it first at bit.ly/kitnadetihai and then we'll go ahead with the rest of the story.
Why do you invest in debt funds? Are you able to quickly give an exact answer to that question? Probably not, because it's actually not a very good question. Let me try again. How are your goals for investing in debt different from investing in equity funds? That should be much easier to think about, and hopefully to answer.
In fact, if you can answer that question satisfactorily, then you're going to be a successful mutual fund investor. However, there are a few more steps after the answer itself which are needed to make sure of that.
The normal - and mostly correct - answer to that question is that you invest in equity funds for high returns and debt funds for stability. Stability means that returns don't vary too much between good times and bad. This answer also points to having a correct asset allocation and towards asset rebalancing. Another common answer is that equity funds are for long-term investing and debt funds are for short-term investing. This actually says the same thing in a different way. The long term and short term suitability of equity and debt funds arises from the same factors that are there in the previous answer.
I bet you have never heard anyone say that they invest in debt funds for high returns. No one ever says that, right? And yet, practically speaking, they do. Investors do this all the time. They don't say so, they don't admit it to themselves, but they do. It happens like this: they decide on investing in debt funds for stability, safety and so on, but then when it comes to choosing the actual fund (or even the category of fund), they start looking at the recent returns of funds! This behaviour seems hardwired in a whole lot of investors.
If you are buying a luxury yacht, then you should surely optimise for luxury. How does it matter to you kitna deti hai? Surely, no matter what you are buying, you should choose on the basis of the characteristic that matters most to you, the one which led you to that product. So when you have decided to invest a certain amount of money in debt funds because of their stability, then please choose on the basis of stability, not kitna deta hai.
In many ways - actually in most ways - the debt fund crisis of the last few years is the direct result of this approach on the part of investors, fund sales people and fund managers. A good chunk of people are unable to evaluate funds on anything except returns. One reason is that at the end of the day, debt funds appear to be very close to being a commodity. From a purely sales and marketing perspective, it's hard to distinguish one from the other unless you get deep into it. The only other way is to start playing games with risk levels and returns. The problem with that is that it's very easy to get into a mental framework where the investor is not able to make the correct trade-off between the two.
I'd hate to say that if investors have got their money frozen in riskier debt funds, then it's their own fault. It's not. The entire ecosystem of fund sales has created a situation, helped along by the obsession with returns alone. Smarter investors have learned a lot from the entire experience.