While Covid and lockdowns have put the world in a general state of chaos since 2020, the stock market has been rewarding its investors greatly for the most part. Hence, seeing the opportunity, many people have invested a lot in the stock market and most have been rewarded handsomely as well. But many of these investors are new, and might not be aware of the precautions to take to avoid making blunders while investing in mutual funds. Thus, this article lists some such common and some not so common blunders that people usually make with mutual funds.
Table of Contents
Blunders to avoid with mutual funds investment
1. Low NAV means more units and high returns
People often think that if a mutual fund has low NAV then it is a good investment option because it would result in purchase of more units and hence more profit. But that is not true at all!
For example, there is Mutual Fund A with NAV of Rs 1000 and Mutual Fund B with NAV of Rs 10. For A, a person can buy 100 fund units with Rs 10,000 and for B 1000 funds units with Rs 10,000. After one year, both funds A and B grow by 30%. Thus, fund A NAV is now Rs 130 and fund B NAV is now Rs 13. If the person now opted for redemption, then from fund A, he would get Rs 13,000 (1000 X 130) and from fund B he would also get Rs 13,000 (1000 X 13).
What is NAV? How is it calculated?
A mutual fund is basically a scheme that pools money from retail investors and further invests it in other opportunities. This investment is done as per the fund objective. Therefore, every mutual fund scheme manages some amount of money at any time which is called Asset Under Management (AUM). AUM includes both fund value as well as cash component. Every fund keeps some cash in hand so that if investors ask for redemption then they can fulfil it without having to sell their holdings.
The simplest formula to calculate NAV is
NAV = (Assets – Liabilities) / Total number of units
From the above NAV, one has to deduct Expense Ratio to get the actual NAV which is published by the mutual fund manager. It is important to also note that expense ratio is deducted on trading days. Mutual fund generally deducts expense ratio when it publishes its NAV. Moreover, since NAV doesn’t change on public holidays and weekends, those days there is no expense ratio deduction. Although, the NAV seen on any mutual fund is always an annualized number.
Who decides number of mutual fund units?
Ultimately the NAV amount depends on the number of units which is decided by the mutual fund. The mutual fund itself decides the number of units it will have. If the number of units is more then NAV is less and vice-versa. Therefore, the unit of NAV does not affect the amount you invest. The mutual fund manager’s capability and its further investments are the real things that matter.
Types of mutual fund
There are two types of mutual funds as follows:
- Growth mutual fund – this type of fund reinvests the returns received from the initial investment. Hence, it helps in growing the money and creating a large sum of wealth.
- Dividend mutual fund – in this type of mutual fund, one can invest a large corpus to receive income from it. Thus, the scheme gives the investor a monthly income from the investment as withdrawal, assuming that the withdrawals are higher than the returns. At one point, the full investment will get consumed. Since the fund is paying more liability its NAV will automatically be lesser than growth mutual funds. However, lower NAV does not mean this dividend mutual fund is a better option than a growth mutual fund!
Will mutual fund grow if its NAV is very high?
It is a misconception that if a mutual fund’s NAV has become very high then it will not be able to grow any further. There is no limit to how much a mutual fund can grow pertaining to its NAV. Just like share prices which can grow exponentially, so can mutual funds. However, companies keep share prices lower purposely to keep them more affordable by splitting shares, etc. Read more about things that company’s do with their shares in 7 Big Mistakes by Beginner Investors in Stock Market.
2. Choosing sectoral funds
When one opts for investing in sectoral funds, they are basically investing in only one business sector mutual funds. This might be pharmaceuticals or banking or F&B or IT, etc. While some sectoral funds do appear very attractive with great performance in the last year, it is important to see their past few years worth of records as well. Also, sectoral funds can fall as quickly as they arise. Hence, investing all the money in just one sector of mutual funds is one of the big blunders since in actuality there is no portfolio diversification happening. One is literally putting all their eggs in one basket!
For retail investors who are beginners, it is recommended to select 2-3 different sectors of mutual funds for investment. For example, firstly one can opt for a Flexi-cap fund, which automatically leads to major diversification of investment in stocks. The second option could be a large-cap fund which has lower risk and most investment is allotted in large companies. These two are more than enough! But one can also pick Mid-cap fund instead of large-cap fund.
Why should we not pick small-cap funds as a beginner investor?
Small-cap funds are also quite tricky to pick! The blunders in these mutual funds are that when stock market crashes, small-fund caps fall drastically and become dirt cheap. Hence, when one invests in them at that point then they may grow exponentially when market rises again, sometimes even more than large-cap funds.
Hence, the market timing is essential to the game here. If done correctly, with right entry and exit, it can be great but amateur knowledge of mutual funds can lead to losses and blunders.
3. Buying too many mutual funds
If one is investing in over 10-15 mutual funds then it means that they are overall investing in all of the country’s mutual funds available. Therefore, their overall portfolio returns will equal the average of all the company’s returns. That would ultimately equal Sensex or Nifty returns. However, if that was the case then one could have just invested in one Index Fund itself! One index fund return would equal the return for all 10-20 mutual funds together.
Investing in every mutual fund for the sake of shiny object syndrome is not recommended. One should have clear goals and select mutual funds according to those goals. This will avoid blunders of having to deal with low performing mutual funds in the future.
4. Investing in lower expense ratio mutual funds
Some individuals feel that if a mutual fund’s expense ratio is low then they should invest in that fund. While expense ratio is important, it should not be the only criteria for selecting mutual funds. As given earlier, the NAV seen on apps or internet is the value after expense ratio deduction. Meanwhile, the mutual fund return value available on apps and internet is also the value after expense ratio deduction. The return value shown will go directly to investors without any further deductions.
For selecting mutual funds, one should look at its past record, its fund manager’s performance, and its returns. If these things are good then pay a higher expense ratio for that fund is valid. Thus, a slightly higher expense ratio with good returns is always better than a lower expense ratio with average returns.
5. Selling mutual funds frequently
One of the last blunders relating to mutual funds is exiting them frequently. Investing in any new mutual funds and simultaneously exiting old ones, for no valid reason, is not a great idea. This is harmful for one’s long term gains.
This is because selling mutual funds leads to capital gain. Thus, one has to pay taxes on it. For example, one was planning to invest Rs 1 lakh over 20 years but withdrew it from various funds over 10 times to reallocate to another fund. Hence, they paid capital gain tax on the profit 10 times which reduced the corpus at every withdrawal. Furthermore, the next investment was a lower amount since the tax was deducted from it at the earlier withdrawal.
Therefore, it is recommended to first research and select good mutual funds. And do not exit them unless there is a strong valid reason for it. Then one can stick with it for a long period and pay taxes on it just once, thus maximising their returns from the fund. Index funds are a good option for this.
Watch the video below for blunders relating to mutual funds and how to avoid them!
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