Five things investors must know before investing in best performing mutual funds

Retail investors generally route their investments through mutual funds to invest in stocks, bonds and gold, since mutual funds are a well regulated and transparent vehicle for doing investments in India. An increasing number of investors are willing to entrust their money to mutual funds. But does selecting the best performing mutual funds ensure investment success? Or are there some important steps that an average investor needs to follow? Here are five things investors must keep in mind:

Patience 

Many times investors want to invest in a scheme to get rich quickly. However, it does not work that way. Investors need to take a long term view of an asset class. This is particularly true in the case of risky asset classes such as equities wherein the long term, the benefit of compounding works in the favour of investors resulting in substantial wealth creation. Top private equity firms are known to have a multi-year view of individual businesses. Generally, they hold investments in individual companies for a period of five to seven years, if not more.

Returns

Many investors tend to forget the age-old principle - today’s investor does not benefit from yesterday’s returns. Investors look at the past year’s returns of best performing mutual funds. Then, they invest in schemes which feature at the top of the list. They don’t realise what has worked in the past need not necessarily work in the future. For example, investors chase long-term gilt funds after they post double-digit returns in a given year. Such a performance is possible only in a year when the interest rates are brought down aggressively. When the interest rates go down, bond prices go up, which helps long-term gilt funds to post attractive returns including on the interest received leading to capital gains. Similarly, when interest rates bottom out, individuals investing in long-term gilt funds for high returns gain average returns.

Be diversified

Not all asset classes rise or fall together. In times of good economic growth, equities typically do well but in a crisis, gold does well; while in a slowdown phase, when interest rates fall, bond funds do well. Betting too much on one asset class can expose investors to concentration risk. Investors with some allocation to gold saw their portfolio’s returns falling less compared to those portfolios with only equity funds in March 2020 amid lockdowns. 

Investors must allocate money to all asset classes – even if a particular asset class may offer the best performing mutual funds in a time period under review. Investors must learn a few lessons from top private equity firms on diversification. Though these firms specialise in some sectors, they diversify their investments across geographies and business models.

Asset allocation

Well-diversified does mean having a large number of investments. However, investors need to make a plan while investing. The choice of investments must be made in the context of the financial goals of an investor. In the case of goals which are due a year from now – say down payment for purchasing a new car, it is better to stick to options such as fixed deposits, liquid funds and ultra-short term bond funds. In the case of long-term financial goals such as saving money for retirement, one can look at a mix of traditional options like public provident fund and market linked options like equity funds. Allocating assets to individual goals bring in discipline. In this way, investors can measure their progress towards their financial goals.

Asset rebalancing

Though asset allocation, in the context of an investor’s financial goals help, the financial plan must be reviewed from time to time. Financial goals change, prices of assets bought also change. In such scenarios, the financial plan needs to be tweaked. A careful review can help investors take corrective action. Sometimes swift changes arising out of volatility in stock markets affects the asset allocation of an individual. But a rule-based approach to asset rebalancing can help investors re-align their financial roadmap to suit their evolving needs.