Prashant is a 30-year-old bachelor from a financially conservative, middle-class background. A finance professional, Prashant wants to build wealth. He has heard stories about investors who made a lot of money riding the bull market cycles over the past two decades. He wants to take the equity mutual fund route to riches. The funds have everything going for them—stupendous one-year returns, diversification, option to make small investments, professional expertise and a proven track record. He is focussing on two funds that have done spectacularly over the past year to invest his savings in. Should he invest more in a sector fund or in a new close-ended fund?
It would be a big mistake on Prashant’s part to base his investment decision on a fund’s oneyear track record in a soaring market. He must realise that wealth in equity is not generated in one or two years. There are market cycles. Bull markets and corrections go hand in hand. The top performers in a bull market are typically hit hard if they are not positioned right during a correction. The fund that performed spectacularly due to its large exposure to momentum sectors and stocks, may get hit the hardest when the market corrects. Therefore, Prashant must not select a fund based only on a single year’s performance. He must look at how it has performed across different market environments. Besides its performance in a bull market, he has to check if it has done a good job in protecting downside losses in falling markets. A few sector funds that may have given fantastic returns during the recent market rally may also look attractive. However, they could be risky. Think technology funds in the late 1990s and real estate, infrastructure and commodity funds after 2007. To ride on their past momentum, fund houses may even launch new funds promising to invest in these focus sectors of the past. There are no shortcuts to building wealth. Prashant must choose diversified equity funds with a performance history. Any new funds must be avoided, because such funds may have been launched to gain from their past momentum, which may or may not be repeated in future.
(The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)