Mutual Funds: Best suited funds v/s best performance

How do most investors end up investing with a particular mutual fund (MF) especially if its an equity fund? Many of them check for the best of the funds available based on the past performance and that too on a timeline which is not arrived through any process but for no obvious reason.

The performances are compared sometimes even across categories but on a specific timeline or across timelines within a category. And why is this done, maybe they believe that's the right approach.

I've encountered people doing further analysis, checking the most recent performances and how they fared i.e. how were the returns in the last one, three or six-month and try to figure out why there's a better performance or underperformance.

This is then juxtaposed with the peer group and portfolio is churned based on these lines. In the hunt for the best fund, in terms of performance, to be always present in the portfolio, investors could hurt their chances of creating higher wealth in the long run.

And there are some other investors who just ask for the top two or three best funds to invest in. They remain perplexed when quizzed about the timelines to invest and the risk they're willing to take.

This kind of approach to investing would lead to undesired effects which would not just impact the returns but also expose the portfolio or investment to undue risk.

The correct method of approaching investing in MF would be to find out the best suited fund than best performing fund. It's always the right fund versus the best fund as the most crucial aspect to be considered is the risk associated with a fund.

One has to remember that returns are an outcome of risk management and higher risk doesn't always translate to higher returns.

Finding the suitability thus becomes a grave importance. And this will lead to the argument of one-fit-doesn't-suit-all. The major factors that define the suitability of fund are the timelines, the risk tolerance and the sensitivity of the goal.

The choice of funds varies when the need changes say from a purchase of car to retirement.

In the case of purchase of car, the sensitivity of the goal would be lesser compared to one where the planning is done for children's education.

Even if the goal is not met due to portfolio underperformance or adverse market conditions, the purchase of car could be postponed but in case of planning for the child's education, the timelines are pretty rigid. One can't postpone their children's education just because required amounts are not available.

So, in this case, the sensitivity of the need turns out to be crucial and thus the choice of fund for this need. A riskier fund could be selected when the timelines are stretched over long periods of time like that of planning for retirement.

But the same funds might not be suitable, however good their performance could be, when the need changes to a shorter or higher sensitive one.

Another ignored factor is the experience or lack of it in the equity markets. When a first-time investor jumps on to the equity bandwagon referred by a colleague, friend or even inspired by some seminar or article, it's very easy for the investor to opt for the best performing fund which could be part of that market momentum.

For instance, during 2016-17 period, many fresh investors have exposed themselves to mid and small cap funds without knowing the intricate risks associated with them.

During a bull run, the fear-of-missing-out (FOMO) is another phenomenon exhibited by investors and rush to take irrational decisions which turn out to be counterproductive. In the hindsight, they enjoy the ride but end up with losses when the tide turns opposite.

The ideal way hence is to create a portfolio of MFs that provide a mix of various ingredients of the market. At this juncture, allocation or proportion to these funds would play an important factor at achieving the goals or needs.

A qualified advisor thus is key for evaluating the needs, identifying the risks and zero-in on the suitable funds that would achieve the defined goals.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)