Why selecting mutual funds based on past performance is a bad strategy

Mutual funds which were once frowned upon are now a common household name. Investors in India alone have invested more than 23 Trillion Rupees in mutual funds. However, a fair chunk of that money might be riding on wrong assumptions. Here’s the thing, the famous/infamous investment clause “Past performance is not an indicator of future returns” is not on the top of our mind when we decide where to invest our money! Truth be told, you can’t really blame investors for falling into this obvious trap.

Historical return is the single biggest benchmark for promoting and recommending mutual funds in India. A trickle-down effect occurs when fund managers take short-sighted decisions to boost returns. This attracts investors who assume that the short-term returns party would last forever only to be let down.

Usually in life, the best way to predict future behavior is by judging past history. However, this method of forecasting holds no value while evaluating investments.It might seem unreasonable to take the most concrete and real information available to you and ignore it.

But you have to!

Why?

Because mutual funds that have shown high returns in the past might have taken on an undue amount of risk to achieve good returns. While they could get away with it during the market upswing, the same strategy could easily backfire when markets take a turn for the worse. If a mutual fund has shown high returns in the near past, there is a risk that the portfolio could be highly overvalued. This would lead to under performance in the future.

What to do?

Moneyjar believes that one should choose mutual funds based on factors other than past performance.

Tell us more!

Before even trying to figure out which mutual fund to invest in, it is important to decide which asset class you wish to invest in and how much risk you are able to take. For the sake of simplicity, let’s assume that your investing period is short and you want lower risk. You would invest in debt funds. On the other end, if you can hold your investment for a longer time period and you are comfortable with higher risk, you would choose equity funds.

The act of choosing an equity or debt fund will help determine most of your future returns. The individual mutual fund you choose will not have a huge bearing on your return.

Once an appropriate proportion of debt and equity is decided, it is important to look at forward-looking qualitative and quantitative indicators to select the best individual mutual funds. Quantitative Metrics include P/E and P/B of underlying equity portfolio, Credit Quality of debt portfolio, Sharpe and Sortino Ratio, Expense Ratio, Max Drawdown, Historical Performance and Rolling Returns over different periods of time, etc. while Qualitative Metrics include Fund House Pedigree, Fund Manager Analysis and Outlook, Fund Objective, etc.

Moneyjar understands that it is not practically possible for the everyday investor to adhere to the above approach owing to limited time and skill. We do all the hard work for the user of determining debt/equity ratio and finding best-in-class mutual funds. These funds are tailored for the investor’s specific needs and we constantly monitor your portfolio post-investing. Don’t take our word for it – check us out here.

Also check out this link to learn more about investing: How to start investing?