One of the books I remember reading while growing up is a book called, “Common Mistakes in English”, by T J Fitikides. That book so helped my mastery of the English language that I often recommended it to my friends and enemies alike. When my kids became of school age, it was one of the books that I bought for them, although they have refused to read it as religiously as I did then.
In those good old days, while reading this book, I had thought that it was only in English language that common mistakes were likely to be made. But coming almost full circle in life, I have come to realize that there are common mistakes made in every sphere of life. One area that common mistakes are found is in the area of investing, so in this article, I have chosen one tiny bit of that investing ecosystem to talk about the common mistakes made there. That area is mutual fund investing.
Mistake Number One: Buying Past Performance: One of the mistakes mutual fund investors make, in an attempt to make profits, is to buy those funds with highest returns. This is called chasing performance. It is, however, quite intuitive, and I have made that mistake in this past— a mistake that I am still paying for. But why is this a mistake? The main reason why buying a fund because it is ranked highest in the list of performers, is that past performance does not predict or guarantee future performance.
For this reason, most mutual fund performance data providers warn those using the data that “past performance does not guarantee future performance.” Fund performance depends on such factors as economic conditions like interest rates. A fund that is up this year may be up next year or vice versa. While performance, as a decision variable, is good, it should not be the sole reason for choosing to invest in a particular fund.
Choosing a fund should be based on a combination of factors like performance, fund manager’s credibility, management style and the fund’s strategy. Rather than buying into the past performance of high-ranking funds, it may be better to buy into conservative but consistent funds. Another reason is that, as is known in investing, the higher the rate of return, the higher the risk— “High risk, high return,” they would say. Because of the higher risks that go with higher returns, buying into high return funds based on past performance, may not align your risk tolerance and risk appetite to such funds.
Mistake number 2: Buying Mutual Funds of Similar Characteristics: One of the reasons that people invest in mutual funds is diversification. Because mutual funds are a pool or a basket of financial assets, by investing in one fund, you get proportional exposure to all the financial assets contained in the basket. However, if you invest into multiple mutual funds with similar strategies or characteristics, you may run foul of diversification.
This is even more so in the Nigerian market space where there are not a lot of securities, so a lot of mutual funds end up holding similar or even the same securities. The danger of this is that by investing in multiple funds holding the same securities, albeit in varying degrees, you encounter concentration risk. One way to avoid this mistake is to find out the correlation between the funds you are interested in. Correlation is a measure of the degree to which two things move together.
If you are interested in two funds that are highly positively correlated, chances are that they invest in the same securities. Therefore, by investing in both, you will not only not achieve diversification, you will also be exposed to concentration risk.
Mistake number 3: Comparing Funds purely on their face value: Selecting which fund to invest in requires research and analysis. However, as noted already, many fund investors select funds without a deep perusal into what the funds invest in. It is possible to get a feel of the future performance or outlook of a fund by looking at its holdings. After all, a mutual fund is as good as the securities it holds.