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7 Mistakes To Avoid When Investing In Tax Saving Mutual Funds - Outside View by PersonalFN

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7 Mistakes To Avoid When Investing In Tax Saving Mutual Funds
Nov 22, 2017

There are still a few months to go before we enter the tax-saving season. Many of you may have already planned your tax-saving investments in advance. But many others may wait till the last hour to completely utilise the tax-saving deductions available under Section 80C.

Among the many tax-saving avenues available, such as Public Provident Fund (PPF), Tax-saving Bank Deposits, National Savings Certificates (NSC) etc., many are flocking to tax-saving mutual funds also known as Equity Linked Saving Schemes (ELSSs). With the falling interest rates on fixed income products, investors are flocking to the equity market in the quest to earn higher returns.

Investments in ELSSs are locked in for three years. This makes it more liquid than the PPF, which has a 15-year lock-in (with partial withdrawal after 6 financial years) and bank FDs or NSCs that have a 5-year lock-in. This adds to the benefits of investing in tax saving mutual funds.

A long-term investment in ELSS is a more prudent choice as compared to other fixed income products. But as with all market linked investments, there is a risk. Blinded by the double-digit past returns, investors often overlook this aspect. Hence, one should invest in ELSSs and other equity funds through a well-defined process.

But all investors tend to give in to their behavioural biases and end up making mistakes. PersonalFN highlights some of the common mistakes made when investing in ELSS.

  1. Investing at one go - in lumpsum (instead of a staggered manner or SIPs):

    Most investors invest in ELSSs in the last quarter of the financial year, at one go. However, this is not the best way to make equity investments. When you invest a lump sum--at one go-- in equity mutual funds, you might expose yourself to a high-volatility risk. Hence, even if you wish to invest lump sum, a staggered approach is prudent.

    The best approach to sail the tides of market volatility, is to opt for Systematic Investment Plans (SIPs), a mode investing in mutual fund schemes offered by mutual fund houses. With this simple technique, you give yourself a chance to accumulate more units when markets go down, and as the Net Asset Value (NAV) falls. But start a SIP in an ELSS at the beginning of the financial year. This will facilitate better rupee-cost averaging while you endeavour to compound wealth over period of time.

  2. Not assessing risk:

    Without a shadow of doubt, consistency in returns is an important parameter successful mutual fund schemes are judged on. Although you assess the returns generated by a mutual fund scheme before investing in it, at times being carried away with the outperformance of the fund in the recent past, you could be overlooking the "compromises" a mutual fund house might have made to deliver higher returns. Hence, always consider risk-adjusted returns.

    If the fund manager is taking the extraordinarily high risk to generate high returns, it might prove dangerous. For example, if a mutual fund scheme is overcommitted to some sectors and has taken concentrated bets only on few stocks, it might generate extraordinary returns until the underlying sectors and stocks are doing well. But when the tide turns, the same mutual fund scheme will start giving you sleepless nights.

    Even the most seasoned investors make this mistake. So it is critical to assess the risk of a scheme before investing in it.

  3. Not aligning investments as per financial goals:

    Do not make any investment without considering your financial goals, risk appetite, and most importantly, current financial situation. Ad hoc investments in tax saving funds will always look misaligned with your goals. While investing your hard-earned money is imperative to fight the inflation, investments must only be done that are in sync with your risk profile, investment objectives, investment horizon, and financial goals. Making ad hoc investments can erode your savings and create a mess of your finances.

    At PersonalFN, we understand the importance of a financial plan and have a firm belief in a research-oriented unbiased approach.

  4. Choosing dividend option over growth while addressing long-term financial goals:

    If your goal is to grow your wealth, choosing the dividend option will end up eating away the accumulated profit at regular intervals. This will have an adverse impact on your path to wealth creation, as your profits won't be reinvested --particularly in case of a dividend pay-out option.

    Hence, if you aren't seeking regular income, it will be best to opt for the growth option. Dividends are often touted to be a benefit as it is tax-free income; however, dividend pay-outs get in the way compounding, which is considered to be 8th wonder of the world.

  5. Following the advice of family and friends to choose mutual funds (opting for Star-rated funds):

    Trusting your relatives and friends is a great thing and may work wonders for your relationships; but unless they have expertise in personal financial matters, take their advice with a pinch of salt.

    Similarly, blindly investing based on the star ratings of mutual fund schemes can prove equally risky. What you need to check is the parameters the rating agency has considered for assigning the "star ratings". Like naive investors, if they too consider give a high weightage to the past performance of schemes, it best to not pay heed. It's better to seek professional counsel from a Certified Financial Guardian then, who is a mark of trust and respect.

  6. Adding too many schemes in the portfolio:

    Investing in different tax-saving schemes every year will not make you any richer. Though, diversification is the core principal for investing in mutual funds, adding too many schemes to the portfolio, especially on the equity side, adds no value. It will lead to over diversification and reduce the potential of your portfolio to generate superior returns.

    Ideally, invest only in handful tax saving funds that are carefully chosen and who will offer exposure to the entire spectrum of the markets. Review you portfolio every year to replace laggards, if any.

  7. Investing in close-ended funds:

    Many fund houses launch close-ended ELSSs with a tenure of upto 10 years. Yes, your investment will be locked up for a decade. Though long-term investing is the ideal mantra for equity funds, locking in your investment for 10 years in a scheme with no performance track record is plain stupid.

    There is no doubt you should invest for the long term, but opt for an open-ended scheme. In the past, we have seen top performing funds losing their past glory, delivering suboptimal returns. In such a situation, you as an investor need to look for better alternatives. This would not be possible if the close-ended fund underperforms. You will be stuck with the investment till maturity. Worse, you will still be paying fund management fees, deducted in the form of expense ratio, for the mediocre performance.

Last minute tax planning can lead to lower savings and inefficient investments. PersonalFN is of the view that you need to plan your taxes at the start of the year, to see where you stand and make adjustments accordingly. It is important for you to know the various routes to save tax on your income. To get started, download our tax planning guide here. It will help you crosscheck whether you are on the right track to saving and planning your taxes and to take timely action before you miss out on any benefits.

PersonalFN provides you with an awesome opportunity whereby you don't have to search for which ELSS mutual funds to invest in. Avail of PersonalFN's Exclusive Report - 3 Tax-Saving Mutual Funds For 2018.

You will find the Top 3 ELSS that are geared to grow your investment multi-fold over long term while saving your taxes. These Top 3 ELSS are handpicked through our special 7-point Selection Matrix methodology, and are considered to be potentially the best tax-saving mutual funds in the Indian market.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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