Investing heavily in a top-performing fund during good times can cause long-term pain
When the BSE Sensitive Index, or Sensex, is at 32,500-odd points, there would be few naysayers about the prospects of the Indian markets — a similar situation as in 2007. And many investors got sucked into this enthusiasm.
On December 31, 2007, Vibhav Kumar, a Noida-based entrepreneur, went to a party where he heard a friend boast about the killing he had made in the stock markets that year. Kumar decided that he, too, would make a fortune by investing in equity mutual funds. The next day, he invested ~1 lakh in JM Basic Fund, 2007's best-performing diversified equity fund. A few days later, after peaking on January 8, 2008, the markets began to correct. As they plunged in 2008, many people Kumar knew booked losses and swore off equities forever. Kumar, however, decided to stay put. Five years later, he was still licking the wounds from his disastrous foray, with the fund giving a compounded annual return of -18.51 per cent during that period.
Best performing fund or flash in the pan? One big mistake you can make when investing in a market that is scaling new highs is to invest in one of the past year's bestperforming funds ( see table: Best performers of 2007). Such funds often don't manage to repeat their performance in subsequent years. In every bull market, certain sectors lead the rally. Funds top the charts by taking a heavy exposure to these sectors. When the markets correct, these sectors often get hit hard and sometimes stay depressed for years. The top performers of the bull run then suffer. "Don't select a fund based only on a single year's performance. Look at how it has performed across different market environments. Besides its performance in a bull market, also check whether it has done a good job in protecting downside losses in falling markets," says Nikhil Banerjee, co-founder, Mintwalk.
Lump sum riskier than SIPs: Another mistake investors commit is to invest a lump sum during a bull run. "With a lump sum investment, you don't get the benefit of averaging down your cost of purchase of units when the markets correct," says Nilesh Shah, managing director, Kotak Mutual Fund. Even if an investor had put money in one of 2007's top-performing funds, he would have suffered in a big way only if he had made a lump sum investment. His SIP returns over five years would have been reasonably good in many of these funds.
No sector funds, please: Investors entering the markets during a bull run should also avoid sector funds. In 2007, the infrastructure sector was at the forefront of the rally. The average one-year return of these funds stood at 81.45 per cent at the end of 2007. Over the next three years, however, they gave an average return of only -7.68 per cent, and over five years, only -8.07 per cent. "Avoid sector funds. We have seen investors lose money in technology funds in the late nineties and in real estate, infrastructure and commodity funds after 2007. These funds are far riskier than diversified equity funds," says Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund.
NFOs aren't cheaper than existing funds: Investors should also avoid new fund offers (NFOs). Typically, when the markets are doing well, fund houses try to raise funds through NFOs by capitalising on investors' bullish sentiments. With Sebi turning stricter about permitting NFOs, not too many sector Lump sum investments atend-2007 would have fetched poor returns, but SIPs would have done reasonablywell fund NFOs have hit the markets during this rally. However, fund houses are launching closed-end funds. Avoid them. Stick to openend funds where you can see the fund's track record. Investors entering equities now should have a long horizon. "Invest for at least 7-10 years so that you have time to recover even if the markets correct," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Stay diversified across asset classes, and equity segments: If you had decided on a 70:20:10 allocation to equities, fixed income and gold, don't change it and go overweight on equities just because this asset class is outperforming currently. Keep rebalancing at regular intervals by selling the asset class that has outperformed and investing in the classes that have underperformed.
Within equities, allocate across categories. You could, for instance, have an allocation of 70:20:10 to large-, mid- and small-cap funds. "Have a bigger allocation to largecap funds because these stocks tend to be more resilient. Don't allow your allocation to mid- and small-cap funds to rise excessively as this is where valuations have turned frothy. Smaller companies also tend to suffer more during a downturn," says Dhawan. Balanced funds or dynamic equity funds (which reduce exposure to equities when valuations are high) can be good ideas. Any money that investors need for, say, their child’s college education within a year, should be pulled out of equity funds and put into fixed-income instruments right away.
The original article could be seen here.