The basics of savings and investing made simple
Moneylife Digital Team 30 September 2010

We look at some crucial details regarding mutual fund investments, why insurance should not be considered an investment and why investors tend to make mistakes

Common misconceptions about mutual funds

Most investors prefer to invest in mutual funds (MFs) rather than trying their hand at picking individual stocks. However, investors still have some misconceptions when it comes to investing in mutual funds, resulting in a poor choice of schemes. Let us look at some of these misconceptions and examine how we can deal with them.

More funds mean more diversification

Unfortunately, some investors think that 'the more, the merrier' applies to MF schemes also. It is not uncommon to find a bagful of them in an investor's portfolio. They believe that owning a spectrum of MF units would broad-base their holdings and offer better diversification. However, all they are doing is buying the same securities under different schemes. This only results in severe dilution in performance. Ideally, investors should not have more than four to five schemes in their portfolio.

NFOs (New fund offers) yield better returns than existing schemes

This is a fallacy that many investors fall prey to. Since the first net asset value (NAV) declared by a fresh fund scheme is low, people tend to assume that the scheme units are cheap. Nothing can be farther from the truth. A new scheme issued at Rs10 does not imply that it will yield better returns than an existing scheme with a higher NAV. It does not matter whether the new fund is being issued at an NAV of Rs10 or Rs1,000. New fund offers (NFOs) by mutual funds should not be confused with initial public offers (IPOs) of companies, which provide better scope for generating high returns. The NAV merely reflects the market value of the stocks held by a scheme as on that date. A scheme with a higher NAV can give better returns than one with a lower NAV, if its stocks perform better in the market.

Comparing funds on returns since inception

Investors often compare the performance of mutual funds based on their returns since inception. However, such a comparison is futile because all mutual funds do not have the same inception date. As such, their returns vary depending on the timing of their launch and the period of existence. For instance, comparing the returns since inception of two funds launched in 2002 and in 2007 would be inappropriate. The returns since inception should be considered only to determine a scheme's relative performance against its benchmark.

SIP is another investment avenue

Systematic investment plans (SIPs) are very popular among investors nowadays, and fund houses have stepped up their efforts to capitalise on this sentiment. Several investors believe that SIP is another investment avenue. SIP is a mode of investing in mutual funds and not a distinct product. Under an SIP, instead of making a one-time, lump-sum investment in a scheme, an investor makes regular investments at pre-determined intervals.

Why insurance should not be an investment

Confusing insurance with investment is a common error and insurance companies have made good business of a wrong notion.

Investors tend to shun pure insurance products in favour of 'insurance-cum-investment' products as they believe that pure insurance products give a raw deal. When somebody puts his money into a financial product, he expects something in return. This is not the case with, say, a term insurance policy, which only offers a fixed amount to the nominee in case of death of the assured. If one doesn't die, one doesn't get anything.

This is where the popular unit-linked insurance plans (ULIPs) come into the picture, as they offer something back to investors regardless of whether they survive the policy term or not.

Investors willingly take the bait as insurance companies sell these products aggressively, wrapping the protection in a variety of investment products which are sold through agents who earn large commissions on premium payments. Most often, these products are not purchased for their insurance benefits. Customers lose sight of the primary role of insurance. Insurance, in its purest form, is a way to provide for your dependents in case of your untimely death.

Even the chairman of the Insurance Regulatory and Development Authority (IRDA), J Hari Narayan, said in an interview with Moneylife recently that the insurance industry has made a mistake in marketing insurance as an investment. "It (life insurance) is a risk product; it is meant for safety and security; its fundamental principle is different. Maybe somewhere along the line, we lost sight of the fact that insurance is a risk cover. To confuse insurance with investment is a mistake. It would be unrealistic to expect insurance to give the kind of returns that one can earn from a well-managed investment," Mr Narayan said.

Indeed, ULIPs are investments and, therefore, should be judged against the returns offered by other investment products. They don't fare too well on this indicator. One of the reasons for poor returns is the alarmingly high expense ratio of these products. The big problem with such products is that an investor has to commit to an unsustainably high premium. Even with the recent changes in the cost structure of ULIPs, the impact of various charges like premium allocation charge, fund management charge, administrative charge and mortality charge, is enough to steadily erode your returns. In the process, you not only end up with low returns, but you are also left under-insured.

Tricks your mind plays

Why do many investors lose their way or end up making mistakes with their investments, when they actually aim to do better? The answer lies in psychology; often it is our mental make-up that leads us to make irrational decisions. Here are some examples.

Price Bias: We appear to be pre-programmed to equate price with quality. This often leads us to commit errors while picking stocks. Just as we tend to judge the quality of wine by its price tag, investors tend to apply this rationale in the stock market. So, the higher a stock price goes, the greater is our comfort. We seem to have an in-built dislike for items that may be available at a discount. Consequently, sound opportunities of investment in quality stocks, at bargain prices, are often ignored by investors.

Loss Aversion: Nobody wants to make a loss on one's investments. We dislike losses more than we enjoy gains. This causes us to hold on to our losing investments over a far longer period, instead of booking a loss and redeploying the money in better investments.

Herding: The herd mentality refers to the tendency of investors to react to market conditions based on what others are doing. It is social behaviour that reflects a contagious emotional, collective feeling which spreads progressively. It is what leads investors to panic and sell at market bottoms and buy at peaks. Very rarely do we see investors take contrarian positions, when the crowd is falling prey to emotions.

Overconfidence: People have overconfidence in their investment abilities. This overconfidence stems from an illusion of knowledge and control. The illusion of knowledge fosters the belief that because we know more, we must be able to make superior decisions. The illusion of control makes us believe that we have influence over things which we don't.

Present Bias: Short-term rewards are more cherished by investors than delayed gratification. Long-term horizons do not naturally come to human beings. The possibility of an immediate reward is far too attractive to ignore. That is why investors have a tendency to book profits at the slightest shiver and, in the process, lose out on long-term opportunities.

1 decade ago
beautiful artcle
it should be read by all
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