Resolve is a series of steps on investing and portfolio management. In the first step, we considered how to quickly select equity mutual funds and build a diversified (equity) portfolio. As a second step, we will consider how to quickly decide if I should stay invested in a mutual fund or exit it. To be frank, the response to part 1 was quite tepid. I think this is because investors still want to choose “top performers” and “best funds” so that they can get married to it via SIP.
The “still” is highlighted because the SEBI categorization rules have changed the way we select mutual funds: How to select mutual funds after the SEBI categorization rules. Selection mutual funds based on past performance is passé! We need to build confidence to select funds looking at our portfolio needs first. The only way to do this is to learn when to exit a mutual fund. If we knew how to review the performance of a fund objectively, we will automatically know when to exit or stay put. This will give us tremendous confidence while choosing mutual funds.
While Reassemble focussed on the basics of money management (download the compiled e-book here), Resolve will discuss basics of investing and portfolio management. So having looked at how to quickly choose mutual funds, let us discuss how to quickly review them. Please note that Resolve ill focus on getting things done fast but with a clear method.
Any method of investing, any method of portfolio management is “okay” as long as we understand its pros and cons and have the discipline to stick to it. The method presented below is far from the best or perfect, but if we stick to it, I am reasonably sure that it will work well.
Should I stay invested or exit my mutual fund? How to decide?
Step 1: Always invest with a clear goal or objective. Why? This will tell you the return you need and the kind of asset allocation you need. Then you can tell which product categories within each asset class will be suitable. Then from within each category, you can choose a product. So the sequence is:
Ask yourself: what is my need? —–> Find out the return and monthly investment required to fund your need in future —> Find out where to invest and in what proportion —–>Select product categories —> select products.
These steps can be automated with freefincal robo advisory software template and my Handpicked Mutual Funds May 2018 (PlumbLine): Revised and Updated
Step 2: Any product that you choose should have a clear purpose. Six months after purchase, if you struggle to define why you got a product, something is wrong! There are unfortunately many investors like this! If you buy with purpose, you can review with purpose.
Step 3 When you buy a mutual fund, always look out for its benchmark
Step 4 Always compare the performance of your fund with its benchmark from the date you started investing. Portals like VR and M* offer interactive performance graphs. You can use the sliders or set to a specific date. This is a simple visual way to compare. See this video for more details
Step 5: Recognise that returns depend on the start date and end date of the comparison. Your impressions of performance will differ from the impression of star rating portals. So it is best to avoid look at last 1Y,2Y, 6-month returns etc and avoid all comparisons with other funds. That is like judging the quality of food in your kitchen by smelling what your neighbour is cooking. If you doing this, you will only get confused. And btw avoid reading the Disqus comments at VR – they are infested with sales guys. It is atrocious that people use that discussion board to get investment advice!
Step 6: After you start investing, give the fund three years to perform. This means beating the benchmark. And beat means higher returns (we could talk about risk-adjusted returns etc, but let us keep it simple for now).
Step 7: If after three years of investing your fund has not beat its benchmark (Total returns index*) then exit in full and buy another fund. That is it. Do this methodically without thinking twice. * Total returns index means dividends issued by the stocks in the index are reinvested.
Let us consider an example: Suppose you start a SIP from Aug 1st 2015 in a fund. Or you start investing manually from time to time from the same date. Do not look at the funds performance for 3Y. If by Aug 2018 the funds return (over the last 3Y period) is say 17% and its benchmark (in the same period ) has returned 15%, stay invested. If the funds return is lower, then exit.
Of course, it would be better if you consider investments in the benchmark on the same dates as you did and then compare, but the above is perhaps easier even though approximate.
Why 3 years? Well, lesser than that seems too soon to expect a fund manager to perform. Many funds do underperform over 1Y or 2Y windows. Lesser than 3Y will mean you will exit and enter funds often and that is not a good idea considering taxes and loads.
Giving a fund manager more than 3Y (say up to 5) is fine with me but not with many others. They see it as a waste of active management fee. If you agree then use 3Y.
Why exit in full and buy another? Otherwise, the portfolio will become cluttered fast. A big mistake that investors do is to leave the existing units in an underperforming fund and buy a new one. If you think the fund is not performing exit in full and buy another. That will keep your portfolio clean. You can wait for units to become free of load and lower or no tax, but you will have to be methodical about it.
Do you practice this yourself? Yes. I have exited underperformers over the last 10Y of investing but as mentioned above, I have given up to 5Y. Also as mentioned before here – How to review a mutual fund portfolio – I focus on the overall portfolio return more than individual performance. I ensure that the best performers in the folio have the highest weights. Since I do not use SIPs, I can do this at the investment stage as well. I have also used rebalancing opportunities to exit poor performers. If there is one thing that I have learnt it is: be ruthless when you exit funds. Do not get emotionally attached to them.
The reason I discuss the “3Y rule” is because it is simpler to understand and get started. Once the portfolio increases in value, you will feel richer and expect less from your funds.
You say be ruthless, but now equity funds are now taxed! Will you stick with an underperformer out of fear of paying a little tax? We will have to individually answer this. I will not.
There is only message in this post: have a method of reviewing mutual funds and stick to it. Do not waver by reading scraps of information here and there – including this place. Remember whatever method you choose, the objective is to have enough money for our goals and not get higher returns.
Plans for Resolve series
I would like to discuss basic portfolio management terminology and consider different tactical asset allocation methods. But before that, is there any basic post that you will be to see as part of resolve? Let me know. Have a good weekend.
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