So you have finally decided to start investing via mutual funds?
After this smart decision, the next step is to choose which mutual funds you want to invest in. Do you, however, know what are you hoping to achieve? Knowing your personal investment goals is as important as starting investing.
This is also where many investors go wrong. Not knowing what they are hoping to achieve, they end up choosing the wrong funds. Here are a few more ways in which choosing mutual funds can be done wrong.
#1. Choosing based on hearsay
Many mutual fund investors are investing in funds because people they know were investing in them. Peer recommendation is a major factor that influences many choices we make. In the case of mutual funds though, investors often end up choosing funds based on uninformed or incorrect advice. Choosing small-cap equity mutual funds just because your trader friend invests in them, might not really work for you.
#2. Choosing a mutual fund because it’s this year’s top rated fund
Ratings can be incomplete indicators of a fund’s likely performance. In the case of mutual funds, many of last year’s top rated funds fail to find a mention in this year’s list. It is far better to choose a fund that had delivered consistently over at least a 5 year period and has been in existence for more.
#3. Choosing a mutual fund because of outstanding returns over the short term
Many investors get taken in by short term performance. Some funds, during market peaks, have delivered extraordinary returns. This influences investors who end up ignoring long term performance because the short term performance looks too good. When market conditions are right even bad funds can do well.
#4. Choosing a mutual fund purely based on returns
Returns seem to be the only focus for many new investors. They end up choosing funds with the highest one year returns, as it seems failsafe and easy. Without keeping your goals in mind though, such an approach can be disastrous. If you need money in three years and you have chosen an equity fund because it’s returns were highest, then what happens if the market tanks in two years? Mutual funds selections should be aligned to your goals, it's timelines, and needs, and not just returns.
#5. Choosing funds only on the basis of low expense ratios
This is something slightly savvier investors fall prey to. Keeping total expense ratios in mind when choosing funds is important, but not the sole criteria to base your selection on. If a fund has a low expense ratio but has not performed consistently, then the low expense ratio hardly matters.
Stick to the basics
Choosing mutual funds is not simple but if you know your timelines and goals, you have the most important starting point when it comes to choosing mutual funds. Don’t get swayed by short term performance. Focus instead on consistency of returns over the long term.