In mutual fund investing, there's complexity and there's complexity, but one is much worse than the other
24-Aug-2021 •Dhirendra Kumar
There are two types of complexity associated with investing in mutual funds. Borrowing from another field, I'll name these 'essential complexity' and 'incidental complexity'. Some of you will immediately recognise these terms and realise how they map to investing. However, the impact of the two types of complexity often gets mixed up and the solutions to ease one ends up worsening the other. It's better that investors understand the difference and why they need to be kept separate in your thinking about investing.
We all invest to meet our financial goals and to solve our future financial problems. Essential complexity arises from the problems one must solve to reach these goals. Incidental complexity arises from the actions of investing being made difficult and cumbersome because of processes or rules or - this is important - our own lack of awareness.
Let me give you an example. An acquaintance of mine recently sold some ancestral property. He now has a large sum of money which he needs to invest for the very long term - an estimated 10-15 years. He would like to invest it in equity and obviously does not want to invest in a lump sum. Since this is a sum of money that is large in the context of his finances, it is best that he diversifies over four or five equity funds, even though the goal and the broad type is the same. In discussion with me, he has chosen five funds. So far, so good. This is the essential part of the investing task; let's now look at the incidental part.
The logical thing to do is that for any equity fund in which you have to invest a lump sum, you should choose a liquid or an ultra-short-term debt fund of the same AMC and invest the lump sum in that. Then, you set up an STP (systematic transfer plan) to transfer a certain part of the money from this debt fund to the chosen equity fund. If there are five equity funds involved, then you have a total of 10 funds out of which money is flowing in and out every month. They all have to be selected carefully, the transactions kept track of, and eventually, the gains accounted for in your tax returns. For an individual who has other things to do in life, it's a lot of work, as well as a certain amount of stress in terms of making the right choices and not missing anything.
My friend's first solution was to just put all the money in one fund, or to not do an STP. Neither of these are good ideas. He was getting weighed under by the incidental complexity, and was trying to reduce the essential complexity. As a result, he was tending to degrade the quality of investments he was making for 10-15 years. Instead, I advised him to forget about the STP and just keep the money in the bank and do an SIP - much simpler and given the short duration of the debt holding and the long duration of the equity holding, negligible compromise on total eventual returns. Reduce the incidental complexity of the process of investing but make sensible trade-offs.
It's commonly believed by many people that it's complicated to invest in mutual funds. Unfortunately, this is true. For someone who is just starting off, it definitely is more complex than it should be. However, we need to ask ourselves, what is exactly complex: the incidental mechanical process part of it or the essential part of it? Nowadays, there are many ways of making the former easier. In some of them, the danger is that you could compromise the quality of your investment choices in the quest to make the process simpler. Many intermediaries - traditional ones as well as modern digital ones - make the process simpler but you pay the price in making poorer investment choices. It's a trade-off you need to be aware of.