How To Choose The Best Mutual Fund? (9 Crazy Simple Tips)
If I tell someone that I am a Mutual Fund investor, the obvious next question that pops out is – “Which is the BEST mutual fund to invest NOW?”
Having seen or heard this question almost every day, I thought it would be a good idea to pen down my opinion once and for all.
Best is Often a Person-to-Person Varying Perception
A couple of months back, I was planning my next holiday and I asked a friend – “Which is the best beach destination that I should go to?” My friend quickly searched his memory of the 4 beach destinations that he had travelled to and 3 more beach places that he knew about. He then gave a 10 seconds thought to his past experience vis-à-vis what he read about the other 3 places and gave me his final opinion. On doing a further research on my own, I realized that ‘his best’ could not have been ‘my best’ for various reasons. And that is when it dawned upon me that “Best” is at best a perception. It is a subjective outcome of our own experience which may or may not be relevant to your circumstances.
Within the Mutual Fund space, the concept of “Best” gets a lot more interesting. And this is because of the manner in which we decide the best funds.
How Do We Select The Best Mutual Funds To Invest In?
A few years back when I first started working, I read about Mutual Funds in one of the News publications. At that point in time, I newly got hitched to the online shopping sites and my phone hosted all the possible apps. While in my heart and mind I knew I was overspending on stuff I didn’t want, the convenience of making a purchase on credit and debit card was enough to encourage me to buy just one more time.
In the midst of this mental conundrum of whether I should save or spend, I came across this publication which spoke about investing in mutual funds. Like everyone else, I wanted the best out of my money. So I started my search for the best mutual funds. The process I followed was as follows:
Type “Best Mutual Funds to Invest”
Open the first four links
Make a list of all funds within those links
Go to www.moneycontrol.com
Check the returns of all the funds that you compiled from the four links
Sort the fund by returns over the last 5 years
Start investing in the 3 best funds
My decision to start investing my hard earned money in mutual funds was as simple as searching for a chocolate cake recipe.
What Happens When We Chase Historical Returns To Establish The Best Funds?
#1. Past returns over short periods of time could be misleading –
Over short periods of time, markets are driven by human sentiments. So a small piece of news can move the prices of good and not so good companies alike. So, the reason behind a fund that performed extremely well over the last 1 year may not be because the stocks it held was really good. But it could be because the short term sentiments resulted in a rally for the said stocks. This is also extremely true for people who choose to invest directly in stocks without spending adequate time in research.
#2. Past returns cannot be perfectly extrapolated into the future –
Future returns will be determined by future circumstances. So just because a fund gave a 25% return over the last 3 years, does not mean it will continue to give 25% return over the next 3 years. This is again extremely relevant for people who look for quick returns. A lot of times people come up to me saying they made a 40% return in a particular stock. I often ask them if they can repeat that kind of returns in future.
#3. Change in fund attributes –
We often sleep over past returns assuming the funds will continue to perform in future. But in an event where the fundamental attributes of the fund changes, such assumptions may be unfounded for. For example, a change in fund manager may be one such event where historical performance cannot be blindly extrapolated into the future.
#4. Ignorance of “risk” –
As investors, we often tend to only look at the returns. Anything which gives high returns falls into the good category for us. However, it is necessary to consider the risk aspect. An investor who cannot witness a negative 20% return on his portfolio for a certain period of time may not be a fit for the small cap funds which sometimes generate over 30% average annual returns. On the other hand, some funds are unable to generate returns which are commensurate with the risk they have taken in terms of their stock ideas. So, the risk is as important an element as return to consider before finalizing the funds.
#5. Ignorance of other factors –
A lot of other fund metrics which deserve consideration while fund
selection tend to be ignored.
But Which Are The “Best” Mutual Funds For “You”?
Now that I have demolished the idea of chasing historical returns for choosing the best funds, you might still be wondering how to select the best mutual funds.
The simple answer to this is that “best” can mean differently to different people. The starting point for fund selection should be -
Determination of asset allocation
Once this is done, several variables should be studied for identifying the good funds within the set asset allocation. Therefore suitability followed by fund strength is what determines the “best” funds for you.
I learnt this the hard way. Initially when I started I didn’t consider the historical returns to start investing. I chose 2 mid-cap funds and 1 thematic fund. I was saving up for a course that I wanted to take around 18 months from when I started investing. When the time came to pay for the course, my returns were at a dismal negative 12%. Since I had no other resource, I had to take the loss and pull out part of my money. Later as I gained more expertise in this field, I realized that 1 of my 3 funds was fundamentally a good fund. I was lucky to have selected it in my basket. But because I needed my money in just 18 months, the good fund was also not generating good enough returns. I had not given adequate time to my investments to grow.
(Also Read - How You Can Become A Financially Wise Woman)
Here's How You Should Go Step-By-Step To Choose The Best Mutual Funds For Yourself
#1. Defining a Time Period & Goals -
In order to decide which funds we should be investing in, the approach has to take a U-turn. Instead of starting from analyzing the funds, we need to start from asking ourselves – Why do we want to invest?
We need to first establish the goals for which we want to plan. It could be a car, a property, own marriage or even retirement. But there has to be a destination for which you save. Having a goal helps you determine the period for which you can let your money stay invested (aka time horizon). Defining the time horizon helps set the roadmap and action plan. In a lot of cases, it also reveals whether a goal is achievable in the said time period or not. Therefore, goal setting together with defining time horizon helps one to set the foundation of their financial planning.
#2. Assessing Your Risk Appetite -
Once you have established your goals and defined the time horizon, it is important to analyze our own risk appetite. Risk appetite too has a dimension of how much risk you want to take, how much risk you need to take and how much risk you should take. It is best to talk to an advisor who can help you assess these parameters.
#3. How Much Are You Willing to Invest -
Once the investor understands his requirements and his profile, an ideal asset allocation for that investor should be established which in turn will help him filter the funds that he should be investing in.
#4. Technical Analysis -
Identifying the best funds comes only after establishing the suitability. Historical returns are only one of the factors that you need to consider to establish whether the fund is good or not. Other parameters such as AUM levels, track record of the fund manager, fund house pedigree, fund manager ideology are equally or rather more important factors to determine whether the fund is a one that you should be selecting.
What is therefore important is that the approach to investing starts from introspection and not from searching for the best investment options. While this may not sound intuitive, it is important because ultimately what matters is whether you are able to fulfill your goals.
And as I sign off, I remember these words that I read somewhere –
“Something magical happens when you write down your goals. It changes the way you see your situation.”
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