A common sense lesson from NASA scientists and Mutual Fund Investing

Image result for common sense cartoon

3 minute read.

When NASA first started sending astronauts into space, they quickly discovered that regular pens would not work in zero gravity. To overcome the problem, NASA scientists spent ten years and $12 billion to develop a pen that writes in zero gravity, upside down, underwater, on almost any surface including glass and at temperatures ranging from below freezing to 300 centigrade. The Russians used a pencil. Yes, the movie 3 Idiots had this real story made into a scene where Aamir Khan is giving this Russian solution. Learning from this story is you should define the problem, identify a simple solution which can be executed immediately rather than complex solution. Many times in our lives we often follow complex path to solve some simple problems, which could have been solved by just applying common sense. 

Same goes true while investing in mutual funds, successful investing needs to be simple and should follow common sense more than anything else. Some simple rules can help you become a better and smarter investor.  

Buy right, sit tight. There is no need to buy and sell funds based on performance variations. Unlike stocks, mutual funds should not be bought and sold based on rise and fall in their NAV. When you have identified your long-term objectives, defined your risk profile, and carefully selected funds that meet your goals, stay the course. Hold tight. And key to holding tight is buying right. Buying right is about using your common sense to avoid some fundamental errors. Post that, you need to monitor your funds no more than once in a year. Unless the fund shows extended periods of non-performance, change in fund manager, a significant shift in its investment strategy or a significant rise in its expense ratio.

Sizing your exposure in different assets is extremely important. A majority of the returns from an investment portfolio comes from asset allocation, meaning, your choice of the asset classes in which to invest and the proportion of your portfolio you choose to invest in these each asset class. Taking a disciplined approach to asset allocation while keeping an eye on the long term, radically improves your chances of achieving your investment goals. Most investors need to consider only three asset classes: Equity for growth, debt for stability and cash for liquidity and size your exposure well based on your risk profile. 

Do not own the market. It is generally unnecessary to invest beyond four or five equity funds. Investing in more than four or five funds will neither reduce risk substantially nor deliver superior performance. In fact, adding more funds to your portfolio could potentially lead to under performance or average performance. Your money spreads across several funds and consequently, any one fund fails to make a substantial impact on the portfolio. It is better to simply invest in an index fund instead of having 10 different equity funds. With far lesser risk and costs in index funds you save yourself the hassle of managing a big portfolio. 

Don’t drive the car looking at rear view mirror. If past statistics show that only 1 is 2 lakh cars met an accident on national highway, it doesn’t mean that there is absolute surety that 1.99 lakh cars are safe. It all depends on how the driver drives the car at that particular point in time. Same goes true with past performance of mutual funds. What matter is how fund manager drives the portfolio in future. Most investors would like to choose funds that have provided outstanding returns in the past. There really is no way to forecast a fund’s future absolute returns based on its past record. In fact, outstanding past performance often guarantees no better than average or even poor future results. This has nothing to do with fund managers and everything to do with statistics. A fund that has enjoyed exceptionally high returns, often reverts to the mean after a painful period of low returns. Past performance should only act as a comfort of fund manager’s relative ability and not his absolute ability to generate returns. Take past performance records with a pinch of salt. Look at past performance with an eye only on risk and consistency of returns. 

Cost is what hits you most in long term investing. Costs are critical, even though they may only represent a few percentage points of investment performance. In the mutual fund industry, costs vary widely from fund to fund. The magic of compounding also applies to costs. So, even if you save only a few basis points in any one year, over a period of time your savings from lower expenses can be substantial. As a general rule: Minimize costs by screening funds according to expense ratios.

Beware of large funds. As funds get bigger, good performance gets more difficult to sustain. Smallcap and Midcap funds in particular. As liquidity in midcap and smallcap stocks is very thin, a large sized fund makes it nearly impossible to invest in attractive smaller opportunities in this space. No fund manager managing a successful large fund will tell you that size is a constrain, but ask a fund manager who runs a relatively smaller fund and he will tell you the truth, hopefully.

Don’t under estimate the role of risk. Risk is the single most important factor in investing. As an investor, you must be sensible about the risk that you undertake and ensure that you maintain a tolerable balance between risk and return. High risk means high variability in returns with better probability of higher returns and lower risk means lower variability in returns with better predictability, but lower returns. Invest in a mix of Largecap, Multicap, midcap and smallcap funds. Have core allocation into Multicap funds and smaller allocation to higher risk funds in Midcap and smallcap space. Getting your asset allocation right is very important to manage risk.  

And lastly, like the NASA scientists, don’t spend too much time in searching for the future best performing fund, common sense says it is nearly impossible to search one.  Instead, follow some simple rules to get other things right and you will achieve the goal you have set for yourself. 

Happy Investing!

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