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Mistakes to avoid while investing in mutual funds

  • Published at 06:32 pm April 25th, 2019
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It is important to have realistic expectations

 A guide on what not to do

Having managed EDGE Bangladesh Mutual Fund for around eight months, we have come across many types of investors. So far, we have been fortunate to get patient long-term investors who ignore the short term volatility of the market.

However, we do sometimes come across those who are susceptible to rudimentary investing gaffes. We are listing some common investment pitfalls below so that you can avoid them.

Investing for the short term in equity mutual funds

Some of our potential clients are interested in investing for short periods of three to six months. They usually have some funds lying around which they want to utilize. This sort of thinking comes from experience of doing fixed deposits in banks which have fixed tenors.

Stocks, by nature, are unpredictable. Even though the “intrinsic value” of companies doesn’t move around a lot, people’s perception of fair values as reflected by ever-changing stock prices can swing wildly. As an example, we have seen DSEX being extremely weak towards the last few months of 2018, but going up more than 8% in January 2019 alone.

This means that investing in mutual funds for the short term is highly risky, and should be avoided. We recommend clients to not invest in stocks if they need the money within a year.

Expecting guaranteed returns from equity mutual funds

We also get queries from clients on what return to expect from mutual funds. This is actually a fairly legitimate query, as they are trying to decide whether to invest in mutual funds or not. However, as per law, no equity fund manager can guarantee returns. We can mention our past return but one must bear in mind that the past is no predictor of the future in stock markets. That is because the asset class is inherently unpredictable.

What has been proven by numerous global studies is that equities outperform all other asset types such as fixed deposits, government bonds, land, gold, etc over the long term. The higher return does, however, come with higher volatility in the short term. The long term investor who can overlook these short term fluctuations will be the winner in this asset class.

Having unrealistic return expectations

Some investors of mutual funds start with unrealistic expectations of returns. Investors seeking returns of more than 25% per year from mutual funds are very likely to be disappointed. What is reasonable is a long-term average return of around 15% (which is still significantly higher than fixed deposits particularly on an after tax basis).

Mutual funds provide equity market exposure, but have some structural safeguards that have been put in place to reduce risk. For example, the fund cannot invest more than 10% of its assets in a single stock or more than 25% in a single industry. This has the dual effect of making the fund safer at the expense of lower potential return.

A herd mentality while investing and redeeming

Human beings have an inherent tendency for herd behaviour. As a result, when the stock market is making highs and our fund NAV keeps rising, we get a lot of interest from clients. Similarly, when the market is falling (dragging our fund NAV down) investors tend to avoid investing in mutual funds. This is actually a global phenomenon and a common mistake that investors make, even in developed markets.

The best strategy, we think, is to do the opposite. When the market has fallen a lot, investors should invest in mutual funds or add to their existing positions. Adding at the peak of the market cycle is the wrong approach.

Conclusion

History has shown that the stock market can be a tremendous wealth generator over the long term. However, one needs to be aware of the points mentioned above to avoid disappointments or regrets.

For example, if you are planning buy a house in three months’ time, that amount should NOT be invested in mutual funds. This decision will benefit both your asset manager and you.

EDGE Asset Management Limited is an asset manager in Bangladesh. For more information, visit www.edgeamc.com.