Buying mutual funds? Read this!

If you think that your job is done once you put your money in mutual funds, then think again. Your portfolio may contain star performers, but common mistakes here and there could well throw your portfolio out of gear. Following these rules will help you avoid the most common mistakes in building and maintaining a portfolio of mutual fund investments.

Strategy

Many investors start investing in mutual funds without thinking of the three Ws: why, when and where. These would depend upon the goals of the investor. An investment strategy that lays down the asset allocation of the investor's funds depending upon his objectives, time frame and risk profile should form the bedrock of any investment plan.

It would ensure that each scheme in the investor's portfolio has a role to play. A well-planned strategy will weed out issues which have a negative impact on the performance of a portfolio. Here's what to watch out for.

Over- or under-diversification. Just as an over or under-diversified MF scheme can throw your returns out of gear, a portfolio with too few or too many schemes can also achieve little. An investment plan without a strategy may result in a portfolio that has too many schemes which dilutes returns without any significant reduction in risk.

One common way to fall into this trap is to subscribe to new fund offers just because they are being advertised. For instance, infrastructure funds should be avoided by investors who already have an infrastructure-oriented fund in their portfolio. Five to seven schemes, that embrace the spectrum of market segments and investment styles, should be adequate to meet the needs of most portfolios.

Duplication. Investing in two or more schemes that follow identical strategies does not bode well for your portfolio. There are same set of companies in them. The money can be used for buying a scheme that adds to the diversification.

Impulse Buying and Selling. One common mistake is investing in funds based on advertisements or other emotional reasons without evaluating the suitability of the fund to the investor's needs.

Investors, who invest in funds based on the 100 per cent dividend declaration without considering factors like its lack of consistent strategy may be investing into a riskier fund.

Only around 10 per cent of the portfolio should be in risky short-term investments.

Overweight in risky funds. When a particular sector or segment is doing well, funds that focus on them tend to give very good returns. This may encourage investors to include these funds in a significant way into their portfolio, making it more risky. Investing heavily in infrastructure funds or selecting equity schemes from fund houses that have just one star performer are a few examples.

Scheme selection

The selection of schemes is made on the basis of evaluation of various parameters such as risk, performance, fund strategy and expenses. Here too, investor is prone to common mistakes.

Relying only on past performance. Buying last year's top performer is the only criteria that many investors use to select a scheme for inclusion into their portfolio. The conditions that made a fund an outperformer during a particular period may not exist in the subsequent years.

Investors who bought mid-cap funds since 2006 based on the outperformance of these funds in the previous years would have seen a fall in the returns in the subsequent years.

A fund's performance should be tested for consistency across time periods and then selected if it matches the investor's need profile.

Ignoring expenses. The expenses that a fund incurs bleed the returns to the investor. Evaluate the expenses that are being charged. Even a small increase in the fund expenses will have an impact on the returns to the investor, especially in the long run. Also, expect to pay around 2 per cent a year in an equity fund.

Not evaluating the fund management team. A fund has to be assessed for the ability of the management to generate returns without straying from its stated investment objectives. Investors tend to focus more on returns than how these returns were generated.

A large-cap fund that generates return by shifting into mid- and small-cap opportunities is shifting away from its charter and is exposing its investors to risks they had not bargained for. The fund may not now fit into the investor's overall investment strategy.

Inappropriate comparisons. Investors compare funds with different investment mandates and end up selecting funds based on performance that do not meet their requirements. For example, it would be unfair to compare infrastructure fund like JM Basic Fund with a diversified fund such as the Franklin India Bluechip Fund.

Investment philosophy

The investment rules by which the investor conducts his investments have a bearing on the long-term performance of the portfolio. Common mistakes that investors make in the investment process are:

Timing the market. Investors lose out when they try to time entry and exit into funds. Entering a fund when the NAV is lowest and exiting when the NAV is highest is not a sustainable investment strategy. A far better option for the investor is to invest periodically into selected schemes and benefit from rupee cost averaging.

Thinking short-term. Chasing short-term gains results in an inefficient portfolio in terms of risk, returns and costs. Investments need to have a time frame that matches the goals of the investors.

Not rebalancing. A portfolio needs periodic review of the performance of its constituent funds to ensure their continued relevance. A run-up in one asset class may have changed the asset allocation of the portfolio, making it more risky than what is acceptable to the investor.

For example, the outperformance of equity funds in the last five years would have increased the equity component in the current portfolio value. Underperformance would have made it too safe.

Rebalancing will ensure that profits earned in these funds are booked and invested in the other asset classes. Once a year is the tax efficient frequency of rebalancing the portfolio. And if you don't like selling winning funds, use incremental investment amounts to buy debt products to get asset allocation in place.

There are no guarantees in the capital markets but avoiding these common errors will increase the potential for long-term investment growth. Follow these pointers and you will soon have a portfolio all set to help you meet your life's goals.