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Why choosing funds first, and then thinking why, is a bad idea

The traditional thinking remains though. Most of us are still buying financial products first without really thinking about the utility.

Mutual funds are all the rage today. They are now offered with the ease which was normally associated with credit cards and personal loans. Considering how apt mutual funds are for most investor goals, this is a great thing.

Many investors have gone a step further and bought into the direct option of mutual funds with gusto. For those who know what they are doing It’s undoubtedly a cost-effective approach to investing in mutual funds.

Of rankings and ratings

The traditional thinking remains though. Most of us are still buying financial products first without really thinking about the utility. 

Based on the latest news reports, new inflows are into funds that returned the best returns over 3-year and 5-year periods. Experts feel that, investors such as you and I are watching fund performance closely and choosing based on that. That makes sense, for a while at least.

The rankings keep changing depending on the fortunes of the market and the individual funds, as they should. This is because while equity as an asset class grows, specific companies and funds can have wildly different fates.

Many financial websites rely on ratings to rank mutual funds within various categories. These ratings themselves are based on proprietary methodologies. Generally, annualised returns play a big role in these rankings. 

The rankings keep changing depending on the fortunes of the market and the individual funds, as they should. This is because while equity as an asset class grows, specific companies and funds can have wildly different fates.

All about performance

Performance matters without doubt. But here is the funny thing. Rarely has a fund retained its number one rank or 5-star rating consistently for years together. There is always a new winner in this game. No one, no matter how smart or with the most advanced technology, can predict the future. And this shows.

Markets themselves can be chaotic over a one to three-year period. In one year “contra funds” might do phenomenally well and the next year the trophy might be won by “focused bluechip funds”. This makes investing based on ratings a hectic proposition, that most investor tire of only after a few years of trying to keep up.

They often end up with scores of wildly different funds across asset classes that don't seem to make any sense for the investor. This is because their needs change and the realisation hits that they need a targeted portfolio aimed at something.

In such a scenario, a goal-based approach is important for people like us. 

Your goals first, then everything else

Whether you are a believer in goals-based investing or not there are certain aspects from this approach that simply make sense, no matter what you are investing for.

Rule 1. Have a goal in mind first 

It doesn’t have to be exact. It doesn’t have to be perfect, but you should definitely have some idea why you are saving and investing. Once you have a goal you will know the next step.

Rule 2. Goal first, asset class second

Your goals decide the asset class you need to invest in. From an investor’s perspective an asset class is a group of investments that have similar characteristics, risk profiles, and offer similar returns. If it is a long term goal then equity makes sense. If it is short term, fixed income does.

Rule 3. After asset class then sub-asset class 

Once you have decided which asset class your investments need, the next step is to figure out the sub-asset class. For example, within equity, large cap equity (or large cap mutual funds which invest in large cap equity) is a sub-asset class. This helps narrow down what kind of returns your goals need based on available time and money. It also helps decide the risk profile of your investments.

Rule 4. Finally, select the instrument or mutual fund

If your goal demands inflation beating returns over a 15-year period then, you might need a portfolio that is largely based on equity and within that sub-asset classes like large cap and mid-caps. You can then execute this plan using large cap, multi-cap, and mid-cap funds to get the best returns as well as guard against traditional equity volatility.

What to remember

Think needs and goal first, then asset class and sub asset class, and finally the actual mutual fund.

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