Mutual Funds Investing Avoid Common Mistakes & Build a Resilient Portfolio

Mutual Fund Allocation Guide

Introduction

Over the past few days, I’ve had invested some time to gather deep insights mutual funds. Thanks to an insightful series of videos and articles from Value Research. It’s been an eye-opening journey for a person like me who has been mostly a direct equity investor (stocks).

In these last few days, what I’ve gained isn’t just scattered facts, but a rather homogeneous perception about how we should truly approach mutual fund investing.

It’s a shift from merely looking at numbers to understanding the very essence of wealth creation.

Let me share some of my key takeaways with you.

1. Looking Beyond Returns in Mutual Funds

Many of us, when we first think about mutual funds, immediately jump to performance.

We look at those shining past returns, hoping to pick the “best” fund.

But here’s the harsh truth: looking at recent past performance is a common and often misleading pastime for most investors.

You must have heard this saying related to investments, “It’s like driving by only looking in the rearview mirror.

That’s a mistake.

A qualified stock investor, like Warren Buffett or Peter Lynch, will tell you that the real starting point for investing shouldn’t be returns at all.

It should be more about choosing the appropriate investment vehicle that aligns with your financial goals.

What does it mean?

If you pick a liquid fund for a long-term goal, or an equity fund for a very short-term need, you’re setting yourself up for disappointment.

Equity vs Debt vs Hybrid Funds

• For equity funds, the true measure of performance comes from seeing a full market cycle. What does that mean? It means the fund has experienced both dramatic market surges and steep declines, typically over a four to five-year period. This helps you understand how it performs when markets fall and how it participates when they rise. If a fund hasn’t been through such a cycle, be cautious.
  • It is also essential to check, if it has consistently beaten its benchmark and peers over this full market cycle. This rigorous assessment will often narrow your choices down to just a handful of good funds.
• For debt funds, the assessment is quite different. You need to evaluate the fund manager’s ability to avoid bad bonds that can default. You also need to see how well they anticipate interest rate changes and adjust the portfolio’s maturity to protect your capital. This is a tricky business, as even the Reserve Bank can surprise fund managers.
• When it comes to hybrid funds, your goal should be different. You want a fund that acts as a better shock absorber, providing a superior cushion against market falls, rather than one that falls as much as a pure equity index.

2. Understanding The Difference Between Risk & Volatility

The term ‘risk‘ often makes us think of big drops in value, or ‘volatility’.

Modern portfolio theory largely defines risk as this volatility, things going up and down.

However, to me, this volatility often feels more like noise.

The real risk is the impairment of your capital. This means losing your money permanently, like when a company goes bankrupt or defaults on a bond.

Volatility, on the other hand, can be temporary.

Markets get ‘crazy’ and go down, but over a long enough period, they tend to recover.

So, if you have time on your side, volatility isn’t necessarily a cause for panic.

Understanding Risk Adjusted Returns of Mutual Funds

For us investors, the easiest way to understand a fund’s risk-adjusted performance is to look at Value Research’s risk-adjusted performance ratings.

These ratings take into account the following:

• How a fund has performed relative to a risk-free return,
• How a fund has performed relative to its volatility, and
• How it stacks up against its peers over a full market cycle (typically three years for their Sortino ratio-based rating).

Cost of Investing in Mutual Funds

Finally, talking about risk, we must also remember the costs.

Once you’ve found several good funds that meet your criteria, and everything else is equal, then the expense ratio becomes the key differentiator. Simply choose the one with the lowest expense.

Cost of investing also includes the exit load. Let me give you a difference perspective about the exit load.

Generally, long term investors do nor care about it, as for them it is zero. But there’s more to it.

When short-term investors exit a mutual fund before a specified period (typically one or two years), they incur an exit load.

In India, regulations mandate that this exit load amount is credited back to the fund itself. Yes, its true. Read about it here under “what is exit load.”

For long-term investors who remain invested, this is beneficial because it means their fund’s overall assets increase due to the charges paid by those who exited early. Essentially, you get rewarded for other investors’ short-term actions of exiting too quickly. How? Because that money is added back into the fund you are invested in.

3. The Right Mutual Fund Schemes

Let’s be honest, finding the “best” performing fund that will stay at the top for decades is almost impossible.

Our goal should be to be in a “reasonably okay fund,” not necessarily the absolute best.

For long-term investors, the core of your equity portfolio, say 80% of it, should be anchored in diversified, well-managed funds. These typically fall into the following few categories:

• Flexi-cap funds: These give the fund manager the freedom to invest across large, mid, and small-cap companies based on opportunities.
• Multi-cap funds: These are mandated to invest at least 25% each in large, mid, and small-cap companies, providing inherent diversification.
• Value funds: These focus on investing in companies that are currently out of favor or appear cheaper, not necessarily chasing growth at any cost.
• Contra funds: Similar to value funds, managers here bet on stocks that the market might be ignoring.
• ELSS funds: These are essentially flexi-cap funds with a three-year lock-in period, primarily for tax saving.

Currently, multi-cap funds seem to be a very strong choice.

Why? Mainly because, they are forced to maintain exposure across market caps.

It preventing over-concentration in large-caps, which can happen with very large flexi-cap funds.

I personally like a quality value fund can be a good supplement to a multi-cap portfolio. This type of fund actually looks like my personal stock portfolio where I’ve accumulated quality stocks when they were not doing so well. For example, ICICI Bank, HDFC Bank, Asian Paints, Nestle, Britannia, M&M, all were bought at times when they were crushed badly.

Investing with Caution

Regarding thematic or sector funds, we must remember that our diversified funds (like multi-cap) already hold significant exposure to various sectors like banking, IT, and FMCG.

So, you’re not really “missing out” if you don’t invest in specific sector funds.

If you do decide to venture into thematic funds, treat them as a tactical allocation.

What does it mean?

Investing perhaps only about 5% of your total money in thematic or sector funds.

This should be driven by a strong, well-researched thesis. The decision should not be made just because a sector has performed well recently.

Also, try to ensure your chosen funds come from different fund families to get diversity in investment styles and avoid overlap of ideas.

And a final tip on portfolio construction

Make sure that any individual fund holds a meaningful position in your portfolio, at least 5%. Why?

Because tiny 2% positions often don’t impact your overall returns significantly, whether they do well or poorly.

4. The Art of Portfolio Resilience – To Weather Market Storms

Markets are inherently volatile and unpredictable. Expect ups and downs.

If you’re a new investor, the initial market declines can be very unnerving. They can even drive you out of the market altogether.

This is why, for newcomers, it’s highly recommended to start with an aggressive hybrid fund.

These funds typically allocate about 75% to equity and 25% to fixed income.

They won’t crumble as much when the market is crashing. Hence helping you build faith in investing without experiencing a massive blow early on.

It might not be as “exciting” as a small-cap or sector fund, but it’s a path to long-term financial success.

If you’ve already accumulated significant wealth, perhaps after a bull run, consider bringing in a “shock absorber”. Gradually move 10-25% of your portfolio into fixed income. This way, when the market inevitably crashes, you’ll have some capital preserved. Even more importantly, you’ll have money ready to invest at lower valuations.

Portfolio Rebalancing

The key to surviving and thriving through market volatility is discipline and a clear asset allocation plan.

Rebalancing your portfolio periodically, for example, maintaining a fixed percentage in fixed income, helps you realize gains in bull runs and provides capital to invest during downturns.

Gauging your risk tolerance is tricky. It’s not a static number. It changes with time, experience, and even your personal situation.

You truly learn your risk tolerance when your investments actually go down in value. It’s like learning to drive a car. Initially, every bump feels big, but with experience, you navigate seamlessly.

If you have a long time horizon (5 years or more), you often have more capacity to tolerate risk.

One of the biggest mistakes we make is reacting to daily noise.

My strong advice is this, for your first three years, try not to look at your investment value at all. Looking at it daily or even weekly can drive you “crazy”.

After three years, perhaps look every three months, and then annually.

This simple act helps filter out the noise and allows the “magic” of compounding to truly happen.

Remember, only invest money you won’t need for at least 5-10 years in equity. And even for long-term equity portfolios, having some fixed income is crucial.

5. Retirement Ready: Debt Funds as A Companion

For many retirees, Fixed Deposits (FDs) are the familiar, safe haven. They’ve been around for decades, offering perceived safety and guaranteed income.

But let me tell you, debt funds actually score better than FDs on several counts:

• Better returns,
• Superior tax efficiency, and
• Seamless liquidity.

Unlike FDs, where you face penalties for early withdrawal, open-ended debt funds allow you to withdraw partially or fully without penalty.

More importantly, debt funds offer a significant tax deferral advantage.

• With an FD, the interest earned each year is taxable, even if you don’t withdraw it. Even if your main principal stays invested, as interest gets credited to your bank account, it will get taxed.
• With a debt fund, the gains accumulate without tax liability until you actually withdraw the money.

This “ultimate tax deferral” is a huge benefit, especially for long-term investments. Even with the recent changes where indexation benefits are gone (read here), this tax deferral still makes debt funds highly attractive compared to FDs.

While debt funds do carry some risk of the loss of capital, this risk is very limited compared to equity.

The declines are usually small (1-2%), and recovery is more predictable. Why?

Because the components of a bond (maturity, coupon, credit rating) are frozen and known. It’s nothing like the 40% drops you might see in equity (see one example of massive price drop here).

For those seeking regular income in retirement, a careful plan is essential.

• For guaranteed income:
  • Government-backed schemes like the Senior Citizen Savings Scheme (SCSS) and Post Office Monthly Income Scheme (POMIS) are excellent options.
• For discretionary debt:
  • Short-term debt funds are suitable.
• And if you’re looking for stable, superior returns that can beat inflation:
  • Conservative hybrid funds (which are mostly debt with some equity) are a great consideration. These hybrid structures are particularly appealing because they get you the benefit of fixed income stability but are taxed as equity. Hence, they potentially qualify for a concessional 12.5% long-term capital gains benefit.

Three-bucket Strategy – Retirement Planning

• Bucket One (Immediate): Keep money for emergencies and short-term needs (like 2-3 months of expenses) in liquid funds or your bank account. This money needs to be absolutely safe.
• Bucket Two (Medium-Term): This is for your income needs over the next 18 months or so. A short-term debt fund is suitable here as it’s less volatile and vulnerable to interest rate changes.
• Bucket Three (Long-Term): Money you won’t need for many years, meant for growth. This can be split, perhaps 18 months of income needs in a hybrid fund, and the rest in equity. The idea is to withdraw from the fixed income buckets and allow your equity investments to appreciate.

Withdrawals From Retirement Portfolio

When it comes to withdrawal rates, be extremely cautious.

Many people overestimate how much they can withdraw.

A conservative withdrawal rate of 5-6%, ideally even as low as 4% of your capital, is advisable, especially in the initial years.

In bad market times, avoid withdrawing if possible. Why? Because big corrections or a crash it eats into your capital faster.

Being flexible with your withdrawals, perhaps taking only half the gains and letting the rest grow, builds a crucial cushion over time.

NPS or Mutual Fund?

Finally, for government employees considering NPS versus mutual funds for retirement.

NPS	Mutual Funds
Employer contributions to NPS are tax-exempt	For your personal contributions beyond Employer’s contribution, mutual funds offer greater tax flexibility
NPS has limitations on equity allocation (max 75%)	Pure equity funds has no maximum cap on equity
NPS restricts equity investments to the top 200 stocks	A pure equity Multi-cap fund can invest in a range of stocks, much beyond the top 200 list.
Mandatory Annuity Purchase	No Mandatory Annuity Purchase

6. Switching Between Mutual Funds

This is a question every investor struggles with.

When should you switch your funds?

I’ve learned there are really only two valid reasons for this:

• Your goals have changed: Perhaps you initially invested for 20 years, but now you need a significant portion of that money in two or three years. It can be due to a job loss or another critical life event. In this scenario, you need to de-risk immediately. Plan meticulously and gradually move your money from equity to fixed income over a short period (6 to 12 months).
• The fund has consistently underperformed: You chose a fund because it was good. But it has stopped doing well compared to its peers or benchmark over a consistent period (three years). Value Research ratings can act as a flag here. If a 5-star fund consistently drops to a 2-star rating, it’s time to consider a change.

Remember, even great funds have lean patches, so don’t react to short-term dips. Also, a fund manager change isn’t automatically a bad sign. Sometimes, replacements can turn out to be even better.

What are invalid reasons to switch?

• Booking profit: The idea that you must sell because a fund has gone up, fearing the profit will disappear.
• Short-term dips: Selling just because your fund has gone down in value.
• Fear of Missing Out (FOMO): Investing in a new fund just because your friend or a salesperson touted it as the next big thing.

We must remember this, “New ideas and thematic funds are often consumer products, sold on a story rather than a proven track record.” For example, we’ve seen new NFO’s coming for themes like PSU, Defence, Infrastructure, Manufacturing, FMCG, etc.

If at all you have decided to switch, what is the way to do it?

Let’s say you have decided to switch due to poor performance. Even in this case, you must move your money out steadily over three months to a year.

But, if the fund is truly horrible, don’t hesitate; in this case you can switch immediately to your chosen replacement fund.

And how often should you look at your portfolio?

While curiosity might make you check daily, the advice is to take a closer look every three months.

Perform a comprehensive annual review to list actionable steps.

This is when you decide which funds to retain, which to sell, and how to adjust your allocation.

If you have too many funds, consolidating your portfolio into a few well-performing funds is a good idea.

However, don’t mindlessly sell reasonably okay funds and incur taxes. Instead, focus on getting rid of funds that are genuinely underperforming or those tiny positions (under 5%) that don’t make a meaningful impact.

Conclusion

The ultimate takeaway from all these discussions is that successful long-term investing hinges on discipline, a holistic view of your finances, and a well-thought-out plan.

Many investors go wrong because they don’t have a clear asset allocation in mind.

There are investors who have the idea of asset allocation, but they fail to rebalance it.

• Asset allocation isn’t just a fancy term. For we investors, it’s a shield. It prevents us from panicking and selling at the wrong time during market declines. It’s like buying insurance for your portfolio. So, what should be our asset allocation? For long-term money, you should ideally be heavily invested in equity initially. As we get closer to our financial goal, we can gradually increase our fixed income allocation. If the final goal is retirement, a significant portion (50-60%) can remain in equity to ensure that our capital continues to grow and protects its value against inflation. It’s also crucial to view your entire fixed income allocation holistically. This includes your PPF, EPF, NPS, bank deposits, and any other fixed income.
• As for rebalancing, it’s difficult to stick to a rigid rule because your risk tolerance and needs evolve. However, a practical approach is to review your portfolio annually. If your asset allocation drifts by more than 10-20% from your chosen target (say, 50% equity / 50% debt, or 75% equity / 25% debt), consider rebalancing it. If the drift is less than 10%, you can often hold off and save on taxes. The biggest challenge here is human psychology. We tend to get greedy in rising markets, making it hard to move money from equity to fixed income. While taxation on rebalancing can be a deterrent, remember that protecting your capital from disproportionate risk is often more important than avoiding taxes.

Investing is not about catching the absolute highs or avoiding every low. It’s about earning, saving, and investing consistently.

Then, after a few years, define your asset allocation, monitor it regularly, and be disciplined enough to stick to your plan, making adjustments only when necessary.

Learn to ignore the noise.

Have a happy investing.