U-turn ahead?

Investors often ask, "Which fund should I invest in?" seeking a definitive answer to what they consider 'the best' option. Unfortunately, this approach is fundamentally flawed. The more appropriate starting point is to ask, "What type of fund should I invest in?" Selecting the right fund isn't about picking from the bottom up but rather approaching the decision from the top down.

Consider the original question - "Which fund should I invest in?" The important word here isn't 'fund' but 'I.' While numerous funds may be suitable for investing, the key factor here is the individual investor. Who they are, their goals and circumstances should drive the decision-making process.

So, let's examine the centrality of the question, "What type of fund should I invest in?" and why its answer is crucial to understanding and benefitting from the cover story of 'Mutual Fund Insight' August 2024 issue. This question forces investors to reflect on their personal financial situation, risk tolerance and long-term objectives before diving into specific fund options.

For instance, a young professional with a high-risk tolerance and a long-term investment horizon might be better suited to putting a large chunk of their investments in full-throttle mid- and small-cap funds. In contrast, a 50-year-old may just need 20 or 30 per cent of such funds in their portfolio. By starting with the fund type, investors can narrow their options to a manageable pool of choices that align with their needs and goals. Moreover, this approach encourages a more unified view of one's investment portfolio. Instead of chasing after the latest hype cycle, investors can work toward a plan.

Everything that I've said so far has always been true. However, the last few years have brought about a twist in the tale, and that's the idea of the primacy of mid- and small-cap funds for high-growth portfolios. The narrative that has taken hold amongst Indian mutual fund investors is that if you want to maximise your returns from equity mutual funds, then the logical choice is to maximise your holdings of small- and mid-cap funds. Now, I'm not saying that this idea is utterly wrong - there is a basis for this belief, as our cover story for the month will show you.

As per the cover story, there is now a sound basis for believing that excessive reliance on small and mid caps in any portfolio is getting closer and closer to the danger zone. While everything in investing is cyclical, the mid- and small-cap universe is cyclical with a vengeance. This is true not just of the funds but of the entire universe of smaller businesses.

What has worked well in recent years may not necessarily continue to outperform in the future. It's essential to remember the inherently volatile nature of small-cap investing.

During bullish market periods, investors often feel a sense of confidence, believing they can weather any market fluctuations due to their understanding of equity dynamics. In these times, equity investing may seem straightforward, and those who warn about risk and volatility might be perceived as overly cautious. Obviously, this perspective can shift dramatically when markets decline and investment values begin to erode daily. It's during these challenging periods that an investor's true risk tolerance is tested.

Ultimately, the key takeaway for investors should be that while understanding market trends and fund performance is essential, the most critical factor in investment success is aligning your investment choices with your personal financial goals, risk tolerance and investment horizon. It's not about chasing the highest returns at any cost but about creating a balanced and personalised investment strategy that can weather market fluctuations and help you achieve your financial objectives over time.

If you feel that the future will be a straight-line extrapolation of the past, you are sure to have a nasty surprise at some point.

Dhirendra Kumar expresses his views on the same in a recent CNBC interview.