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10 commandments for investing in mutual funds

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I thought to write an article on "where to invest in the year 2013". I appreciate the fact that all of us are looking for these readymade answers to our financial problems but then this is like feeding fish to a person. I thought and pondered that rather than giving fish to the readers and feeding them for one day, why not teach the readers how to fish themselves and make their tummy full for life. So, I ventured on writing the "10 Commandments on Mutual Fund investing", which, I hope, will give financial freedom to the readers and what better a New Year gift than freeing somebody from money and its problems.

Money is a very strange thing-human beings make rational decisions while dealing with most aspects of life but make serious errors of judgment when it comes to dealing with money - while dealing with different aspects of money and finance including earning, protecting, budgeting, saving, spending, leveraging, investing and insuring.
 
Completely rational investors take totally irrational decisions when part of crowd. Many a times, individual rational intelligent persons commit simple mistakes while making investment decisions. And those mistakes get compounded while investing in mutual funds.
 
I lay down the "10 Commandments on MF investing" which will help in leading you on the path to achieve financial independence.
 
Commandment 1: Thou shall make a proper Asset Allocation Plan
 
Asset allocation is the primary premise for investments. Long term statistical analysis has shown that 90 per cent of portfolio variability is due to asset allocation, while only 10 per cent of the variability in portfolio performance is due to market timing and stock selection. The only thing in your control is asset allocation. But, the good news is that 90 per cent of portfolio variability is due to asset allocation.
 
Remember that all assets move in business and economic cycles of their own. While one asset might be in a bear market, there might simultaneously be another asset class in a big bull market of its own. The broader fund groups of equities, bonds and commodities (others being real estate and art) will lead you to the gateway of long term wealth creation and sustenance.
 
While allocating assets, remember to allocate only that much money to equity funds which you won't require for at least the next 5 years, and which you can afford to lose up to 50 per cent in the short term without any panic.
 
Risk and return are inextricably entwined. As a general rule, do not expect higher return from safe investments. However, do expect higher long term wealth creation from optimal asset allocation in a portfolio comprising of various funds.
 
Portfolios behave differently from their individual constituents. The aim of an optimal asset allocation is not to invest only in safe assets, but to invest in a combination of safe and risky assets whose combined risk is much less than the individual constituents, while simultaneously offering a higher degree of return.
 
Therefore, focus on the behavior of your portfolio and not its constituents. Small portions of your portfolio will often sustain serious losses, but will cause only minor damage to the whole portfolio.
 
Commandment 2: Thou shall regularly invest budget surplus in MFs
 
Try to create a budget surplus by ensuring your income is more than your expenses. Then, channelize your additional income properly into investments like mutual funds. Make sure that investing is a priority along the lines of payment for government taxes, bank loan installments, utility bills, school fees etc. Then start a proper systematic investment plan (SIP) in your favorite MF schemes keeping in mind Commandment 1.
 
Commandment 3: Thou shall not over invest in Liquid Funds
 
Liquid Funds are only for parking "temporary surplus" and not for long term investments. If you believe that liquid funds are for long term investments then you believe in the fallacy that 'saving is investing' and will be in for a rude shock.
 
The rules of money permanently changed in the year 1971 when the then US President Mr. Richard Nixon took the US off the gold standard and granted itself the license to print money. Since, then the US dollar and other currencies have depreciated, while the price of all commodities measured against it -- be it precious metals like gold, silver or industrial metals like steel, copper, aluminum or agricultural commodities - all have gone up and will continue to go up over the long term. That's why we call money 'currency'.
 
In this modern age of currency - the value of which is continuously and incessantly losing its value -savers are losers. Hence, Liquid Funds are to be used just as an instrument to park temporary funds in order to earn superior return on your short term funds as compared to bank deposits and not as a long term investment vehicle.
 
Commandment 4: Thou shall not ignore Equity Funds
 
Thou shall not ignore equity funds because they are the gateway to long term wealth creation. If you ignore equity funds and only invest in debt funds then you are committing a grave mistake, which may considerably hinder your long term wealth creation potential. In a risky all-bond portfolio, addition of a small amount of stock actually reduces the risk marginally, while improving the return by a considerable amount. The corollary to this would be that addition of a small amount of bond to an all stock portfolio would significantly reduce risk, while only marginally bringing down the return.
 
Commandment 5: Thou shall not commit the common mistakes while investing in MFs
 
Many a times, rational intelligent individuals commit simple mistakes while making investment decisions, which then get compounded while investing in mutual funds. Fund managers, marketers as well as the markets themselves have its own ways of finding and exploiting human weaknesses. I try to mention some of them below:
  • Don't imagine that a low Net Asset Value (NAV) is cheap while a high NAV is costly. A MF unit in itself has no value - it is 'not' an asset like a house property, bond, equity stock, gold etc. Yes, the MF unit in itself simply has no value on its own - it derives the value from the underlying asset which it owns. The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units. If the value of the underlying investment goes up, then the NAV will go up and vice versa.
  • Buying MF New Fund Offers (NFO) at 'par' is another derivative of the first mistake - an investor can't become more foolish when he / she invests in a MF NFO simply because it is available at 'par value'. As explained above, the MF NAV is meaningless in itself as it is merely the value of the underlying asset. Therefore, buying a MF unit because it is available at par value would be one of the silliest mistakes that an investor can commit with.
  • A grave mistake which investors do is sell winning funds while stick on to the loosing ones. It's important to be realistic about investments that are performing badly including MFs. Recognising the losers is hard because it's also an acknowledgement of your own mistake. But, it's important to accept and book a loss or else future loss would be even higher.
  • Paying too much credence to recent past performance because if you give too much importance to 'continuous performance by looking at daily NAV' then you are inviting unnecessary worries for you in the form of selling a good fund and moving to a not-so-good fund, which also adds to extra costs like fees, commission, tax, etc.
  • Fund churning is a common advice that might be showered on you by your MF distributor. Instead of churning your fund, just churn the MF distributor who gave you that advice. Distributors love the churning game - simply because it gives them extra commissions and fees, while it gives you extra income tax expenses and most probably a sub-optimal fund.
  • You may be put in the dividend temptation web by the MF distributors and marketers to take advantage of 'free' dividends by investing in a fund that is trading cum-dividend. But, there is no free lunch in this world - particularly not in the world of investments and mutual funds. The dividend which a fund pays to an investor is immediately reduced from the NAV of the fund.
    On the contrary, I would advise not to invest in a fund that has declared lofty dividends because that is against your purpose of investments - you are entrusting your money to the fund manager to manage it on your behalf accrue good returns.
  • Don't fall victim to fancy funds, fads and fantasies. Many new funds and schemes prop up during times of exuberance. Banking funds will be launched, when banking stocks have performed well, infrastructure funds, when the infrastructure stocks are rising, or IT funds, when the technology boom is underway, so on and so forth. These sector funds are simply smart tactics to collect money from gullible investors. No sector continuously performs well over a long term period. Even worse, a sector fund is generally launched after the sector has already performed well because the fund has to show good past performance to attract fresh investor money.
    Also, by applying the 'law of averages', it becomes more likely that the sectors, which have already performed well in the past, will not really perform all too well in the future. Hence, never fall prey to fund gimmicks and invest in sector- or theme-based funds.
 
Commandment 6: Thou shall protect yourself from fund robbers
 
Thou shall invest in the fund which shields and protects you from all the five major fund robbers - inflation, income tax, interest rates, market volatility and incorrect asset allocation. And the fund which protects you from all the 5 fund robbers is the simple, but ignored - balance funds.
 
A balance fund invests both in equities and debt. The equity component in the balance fund protects your money and investment from the big silent monster of inflation.
 
As far as tax is concerned, balance fund is treated as an 'equity fund'. Hence, on one hand its dividends are tax-free, while on the other hand, it is outside the purview of long term capital gains tax. The beauty of it is that even the debt portion becomes tax-free as equity, which never happens in any other case.
 
It also shields you from the third robber, namely interest rates as the equity component in the balance fund protects your money and investment from the dangerous monster of interest rates.
 
Further, a balance fund invests in both equity and debt and hence takes care of market volatility via playing the 'investment cycle'.
 
Lastly, but most importantly, a balance fund allocates between equity and debt and hence providing the investor with automatic asset allocation - it almost automatically buys the cheaper asset and sells the costlier one, when one asset class outperforms the other, so as to bring the fund back to the optimal asset allocation.
 
Therefore, it, by definition, follows the most important principal of investment - buy cheap and sell dear.
 
Commandment 7: Thou shall not ignore index funds
 
This is another very common mistake which MF investors commit - ignoring a simple low cost index fund in favour of the high-cost-actively-managed fund. You will often be adviced to entrust money to expert fund managers while investing in equity, especially if you don't know how to pick your stocks. However, I dare to say that this is probably one of the most useless advices that you can ever receive.
 
Hold on, I am not saying that you don't entrust your money to the experts and start picking your own stocks; no, there may not be a bigger financial suicide than this. I just humbly submit that it's very difficult, if not impossible, to beat the stock market indices consistently over a longer period of time. If that were not the case, then why would approximately 75 per cent of all actively-managed stock funds underperform the passively constructed stock indices over a period of a decade or more?
 
The fact of the matter is that most people have no reason whatsoever to believe that they can pick winning stocks or time the markets, and their success at it would be the same as it would be like throwing darts at the financial pages.
 
I would like to quote Dr. William Bernstein who told that "there are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know where the market is headed. Then again, there is a third type of investor - the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know where the market is headed".
 
Nothing more succinctly explains the real world of professional investing and stock picking.
 
Mr. Merton Miller, Nobel laureate and professor of Economics of Chicago commented that "if there are 10000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful, but they're really not".
 
Then I would quote Rex Sinquefield, co-author of Stocks, bonds, ills and inflation that "we all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it".
 
Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices!
 
Then for the investors who are always on the look-out for the next hot fund, the next great sector fund or so, Bethany McLean, columnist for Fortune magazine wrote "skepticism about past returns is crucial, the truth is, much as you may wish you could know which funds will be hot, you can't and neither can the legions of advisors and publications that claim they can. That's why building a portfolio around index funds isn't really settling for the average. It's just refusing to believe in magic".
 
And let me further quote Jon Bogle, founder and retired CEO of the Vanguard group "Index funds eliminate the risks of individual stocks, market sectors, and manger selection. Only stock market risks remain".
 
 In other words, when you invest in a passively managed index fund than all the risk relating to the fund manager, his / her stock selection and market timing, individual sectors etc all go and the only risk which remains is the risk of the whole stock market and that is precisely the risk which would like to expose yourself to when you invest in equities.
 
Nicholas Taleb has written an excellent book titled "Fooled by randomness" wherein he explains the role of chance in life and in the markets and I will recommend that book to anyone who believes that he / she can consistently pick winning stocks and / or time the markets to perfection.
 
Last, but not the least, I would like to jot the words of the great legendary investor Warren Buffet who once said that "most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals".
 
Commandment 8: Thou shall understand the fund in which you invest
 
The primary purpose of MFs is to make your life simpler by investing your money on your behalf. However in reality, they have made your life difficult by making available a plethora of different categories and schemes. Hence, before biting the bullet, get acquainted with the category of fund you are investing in - Equity, Fixed Income, Balanced, Commodity - and within them the various sub-sets like sector, theme, gilt, income, short-term, liquid etc..
 
The risk, expected return, income tax, expenses, required time horizon are immensely different in each of those categories. So don't commit the unpardonable mistake of investing your money in a fund without actually knowing where and in which asset class it is going to deploy your money.
 
Commandment 9: Thou shall not believe that MF is the only way of investing
 
You would be advised by all MF managers, distributors, sales persons and media that mutual funds are perhaps the best and most superior way of investing in the markets. No doubt, MF is surely an attractive platform for investing in the markets particularly when it allows you to invest in certain instruments or under certain conditions which you otherwise cannot do as an individual, like buy government securities or getting complete diversification by investing a very small sum.
 
However, there is no reason to believe that a MF manager would do a better job then you; in fact, if you gain some financial knowledge and then practically apply your knowledge around your own niche area, there is every likelihood that you might do better than the average fund manager. This is what the ace fund manager, Peter Lynch, beautifully brought out in his bestselling book "One up on Wall Street". So, do invest in MFs as it offers superior risk-return parameters but don't make the mistake of believing that MF is the only way of investing in the markets.
 
Commandment 10: Thou shall not forget your MF investments
 
The title of this commandment might seem paradoxical, but it is true. Most of the investors just invest and forget about it. They think that their job is done by just investing, little realizing that their job has, in fact, just begun. You need to periodically review and monitor your MF portfolio.
 
Kindly note, I am not suggesting you to monitor the daily NAV - that would be disastrous and against the principle of Commandment 5. What I am suggesting here is that you should periodically review the MF schemes so as to ensure that the fund has adhered to its original investment premise, whether your decision to invest in a particular scheme was correct, whether that particular scheme still fits into your overall asset allocation goals etc. You may take corrective actions, if need be.
 
Mehrab Irani is the General Manager - Investments with Tata Investment Corporation Limited. 

Story first published on: January 27, 2013 16:26 (IST)

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