Investors' Hangout: Top 5 investing mistakes and how to avoid them

In this episode, we will talk about the top five mistakes that investors make and how to avoid them. It's really important, and we found a beautiful reference in Peter Lynch's One Up on Wall Street. He talks about stocks mainly, but let's adapt it to the realm of mutual funds, which can easily be done.

When it comes to investing, everybody tells you how to invest, but what not to do is a longer list. There are very few things you need to get right, but the learning curve is long because it is filled with all kinds of things you will be tempted to do, and that looks natural. Here, I think Peter Lynch's One Up on Wall Street is a classic when it comes to investment books or anything related to markets or finance. It is filled with formulas and jargon, but here is a storybook that every interested investor should pick up and read. It will feel like, if you're interested in business or understanding how businesses are run and what the investment potential is, it will be a very easy read. You will be able to relate to the things, and the mistakes pointed out are very, very relevant. They're all about stocks, but they're equally applicable to mutual funds too.

First mistake: Avoid hot industries

Peter Lynch said to avoid hot industries, and that is investors' favourite pastime, and it happens in mutual funds as well. Right now, artificial intelligence is a hot topic. In India, it has happened with mutual funds as well. If you recall, it started with technology, before that petroleum and refining companies, sometimes PSU, sometimes infrastructure. Investors get carried away because there is some reality to it, but people extrapolate, and we lose objectivity. Chasing hot industries can be translated into chasing recent performance. Normally, it's a theme or sector where industries are making money, and people don't really understand. You usually catch on after it has already done well. To benefit, you need to invest before it happens. You need to do something repeatable, where the likelihood of success is higher. It's very important for investors not to get attracted to hot industries, hot sectors, or hot thematic funds, and avoid them at any cost. That should not be your initial investing vehicle, even though it will always look attractive.

Second mistake: Focusing on the next big thing

It is a variation of the first: the market is filled with noise about the next big thing. The world is changing, and if you look at the last 20 years, the way businesses are changing, most recently, it was startups. Look at the listing of the startups and the companies and funds investing in those, like Zomato. There are many other companies where investors invested and lost money in a very meaningful way. The betting ratio for something unknown, like the next big thing, is high. Success is very low and investors latch onto it, but history proves that when you get attracted to such things, they rarely work out.

In mutual funds, funds that get attracted to such strategies may stack at the top of the pack, but that is unique to understand. Something doing extraordinarily well by concentration, it is not a thematic or sector fund but some next big thing, is getting emphasised in the portfolio, and it should be avoided at any cost.

Third mistake: Diversify a lot

Diversification is a good idea, but many times people think that if diversification is good, they should diversify a lot. Peter Lynch coined the term "diworsification," meaning diversifying for the worse. For example, someone invested Rs 25,000 in a mutual fund spread over 25 funds with a Rs 1,000 SIP in each. This is madness. Diversification is good, but too much diversification is not helpful. It adds complexity and leads to a lack of interest. Some funds will do well, some will do very poorly, and you won't be able to figure it out. It's very important for investors to understand what they are doing and why. You can achieve diversification with one or two funds. Over-diversification drags performance, incurs the cost of active management, and may make you worse off than an index.

Fourth mistake: Selling early

Most investors think that because their investment has appreciated, they must take their money out. They don't understand that equity is a long-term vehicle that will keep going up. Sensex started at the base level of 100 and now it has grown tremendously. The underlying businesses are growing, changing, and as a result they appreciate. Therefore, equity investments will keep appreciating. You should have a sell strategy based on your goals, not market levels. Sell your investment if it has fulfilled your goal, or it has turned bad, or if your money has appreciated enough and you are feeling scared. In the third case, sell some of your investment and rebalance your portfolio. These are reasons to sell, not the market highs. They are internal to you. If you would have sold your investment during earlier market highs, you would have lost all the upsides, i.e., the highs that the market is reaching now.

Fifth mistake: Timing the market

Investors believe they can time the market. The market is either going up dramatically or down dramatically, and it's dramatic all the time. Most investors think they can perfectly time it, but it's easier said than done. No mutual fund manager has consistently been able to call the market. If you sell and the market goes down, it becomes impossible to get back in. The psychology is against you. Timing the market is very difficult, and most big moves happen when you least expect them. Choose good funds or stocks, stick with them, and control what you can: your timeframe, asset allocation, rebalancing, and diversification.

Viewer's question

We have a viewer question from Manjunath, who is 42 years old and seeks advice on rebalancing his portfolio for the next eight years. He is wondering if he should choose hybrid funds. He can invest Rs 50,000 every month, including his existing SIPs of about Rs 78,000. How much can he expect to earn with the new money he's planning to invest?

It's difficult to guess how much return to expect, but with new money invested steadily for eight years, I'd be happy with 30-40 per cent more than a bank deposit. That translates to about 10-11 per cent return, considering a risk-free return of 7-7.5 per cent in a bank deposit. SIP averaging helps optimise returns a bit. For rebalancing and choosing hybrid funds for long-term investment, it's a good idea. Once you have accumulated something substantial, it acts as a de-risking strategy. Though hybrid funds will also go down, they won't decline as badly as pure equity funds.

Click here to register for the next episode of Investors' Hangout.