- Date : 13/03/2023
- Read: 5 mins
Many people invest in last year’s top-performing schemes based on recency bias and herd mentality bias. That is not the right approach. We discuss 7 parameters for selecting a mutual fund scheme.
Many individuals follow the recency bias and/or herd mentality bias for investing in mutual funds. They look at the best-performing funds for the last year and invest in them. However, studies have shown that most of the last year’s top performers don’t figure in the next year’s top performers. In this article, we will understand why it is not a good idea to invest in last year’s top-performing funds. We will discuss what are the parameters that you should look at for mutual fund selection.
What is the recency bias and herd mentality bias in mutual fund investing?
Recency bias refers to giving importance to recent events/happenings and accordingly taking decisions. For example, remembering favourite movies, sports events, holiday trips, etc., there is a recency bias related to most of them. The same recency bias applies to investing also.
Many investors choose a mutual fund for investment based on its recent performance. For example, they look at the last 6 months to 1-year returns and accordingly take an investment decision. They expect the good performance to continue in the future and hope they will make good returns from it. The same recency bias applies to investing in stocks, cryptocurrency, and other investments.
The other reason why people invest in the last year’s top-performing mutual funds is that other people they know are also doing it. Here, the herd mentality bias comes into the picture.
Why shouldn’t you invest in last year’s top performers?
In 2022, the recency and herd mentality bias hurt FAANG and cryptocurrency investors. In 2020 and 2021, many investors, including Indians, invested in the FAANG stocks as they gave very good returns. In 2022, the bubble busted, and FAANG stocks fell between 20 to 70%. Similarly, cryptocurrencies did very well in 2021, and then they collapsed in 2022. Bitcoin fell around 60%, and altcoins fell even more. In 2023, investors are hoping to recover the losses.
Between 2020 and 2022, two very distinct themes emerged in equity mutual funds. In 2021, IT mutual funds were table toppers. But, in 2022, the IT mutual funds were at the bottom of the performance table.
Similarly, in 2020 and 2021, banking mutual funds were languishing at the bottom of the performance table due to fear of NPAs, low credit demand, etc. But, in 2022, banking mutual funds jumped to the top of the table. Expectedly, everyone is investing in them now.
How should you select a mutual fund for investment?
Some parameters that you should consider while selecting a mutual fund scheme include:
1) Risk profile
When choosing a mutual fund, you should consider your risk profile. If you have an aggressive risk profile, you may look at equity mutual funds for investment. Else, if you have a moderate risk profile, you may look at hybrid or debt mutual funds.
2) Compare returns with the benchmark and peers
You should compare the returns of the mutual fund scheme with its benchmark. For example, a large equity fund may have the Nifty 50 or the Nifty 100 index as its benchmark. Check how the scheme has fared against the benchmark over medium to long periods. Compare the performance of the scheme with its peers. If the scheme is consistently outperforming its benchmark and peers, it is a good candidate for investment.
Also Read: What To Do When Mutual Funds Are Down?
3) Compare returns with your expectation
When you are making your investment portfolio, you have an expected rate of return from each asset class and from the blended portfolio. You should compare the expected rate of return from the scheme with your expected rate of return. If the expected rate from the scheme is higher than the expected rate of return, you may consider investing in the scheme.
4) Consistency of returns
Look at the consistency of the returns provided by the scheme over the medium to long term. If the scheme has been performing well consistently, you may consider investing in it.
5) Investment time horizon
If your investment time horizon is less than 3 years, you should invest in debt funds. For an investment period of 3 to 5 years, you may consider hybrid funds. For an investment period of more than 5 years, you may consider equity funds.
6) Tax benefits
If you are looking for tax benefits at the time of investment, you should invest in an Equity-linked Savings Scheme (ELSS). In a financial year, you can avail of a deduction of up to Rs. 1,50,000 from your taxable income under Section 80C of the Income Tax Act. However, there is a lock-in period of 3 years in an ELSS.
7) Scheme-related details
Check the scheme-related details such as the AMC’s history, fund manager’s performance, etc. Compare the expense ratio of the scheme in the same category.
Top performing sectors/themes
Let us look at the sectors/themes or broader market capitalisation funds that have given the best returns in the last few years.
What should be your overall portfolio approach for selecting mutual funds?
When selecting mutual funds, you may take a core and satellite portfolio approach. The core portfolio can have a combination of the 4 index funds based on the Nifty 50, Next 50, Midcap 150, and Smallcap 250 indices. The core portfolio will give you exposure to India’s top 500 companies with zero overlaps at a low cost. The satellite portfolio can include sectoral, thematic, smart-beta funds, etc. Having a core and satellite approach is easy from a portfolio management point of view. The core portfolio can stay intact for the long term for wealth creation. You may follow the SIP investment route. You can make changes in the satellite portfolio based on market opportunities in the short term.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas.