Systematic Investment Plan (SIP) has gained immense popularity among retail investors in recent years. SIP allows investors to invest a fixed amount regularly in a mutual fund scheme, providing the benefit of rupee cost averaging and disciplined investing.
However, one common misconception among investors is that they should invest in a top-performing mutual fund. In this article, we will explore the reasons why blindly investing in a top-performing mutual fund might not always be the best strategy for long-term wealth creation.
Past performance is not indicative of future results
One of the critical points to consider is that past performance is not necessarily a reliable indicator of future returns. Mutual fund performance is subject to market fluctuations, and a top-performing fund today may not sustain its outperformance in the future. Market conditions and economic factors change over time, affecting the performance of even the best-performing funds.
Mutual fund performance tends to follow cycles, with different fund categories outperforming and underperforming at different points in time. A top-performing fund might be at the peak of its performance cycle, and investing in it now may expose investors to potential downside risk when the cycle turns. Instead, it is essential to consider a fund's long-term track record and consistency across various market cycles.
Chasing returns can be risky
Chasing returns by investing in a top-performing mutual fund can be a risky approach. Investors may be tempted to switch funds frequently based on short-term performance, which can lead to higher transaction costs and tax implications. Frequent switching can also disrupt the power of compounding, which is a vital factor for wealth creation through SIP investments.
A top-performing mutual fund might have a concentrated portfolio in a specific sector or a few high-performing stocks. While this concentration can boost short-term returns, it also increases the fund's exposure to sector-specific risks or individual stock volatility. Such concentrated exposure can lead to higher volatility and losses during market downturns.
A top-performing fund might have already witnessed significant capital appreciation, leading to higher valuations of the underlying assets. Investing at elevated valuations can reduce the potential for future returns and expose investors to the risk of a market correction.
Investing in top-performing mutual funds might provide higher returns, but it is essential to evaluate whether the risk associated with these funds aligns with your risk tolerance and investment objectives. High-performing funds might be more volatile and unsuitable for conservative investors or those with a shorter investment horizon.
Fund size and flexibility
The size of a mutual fund can impact its performance. A top-performing fund with a significant asset base might face challenges in deploying funds efficiently, limiting its flexibility to invest in smaller or mid-cap stocks with higher growth potential. As a fund's size grows, its performance may start to converge with the broader market.
Investing in multiple mutual funds across different asset classes and investment styles offers diversification benefits. While a top-performing fund might be an excellent choice, having a diversified portfolio can help reduce overall risk and enhance long-term returns.
While it may be tempting to invest in a top-performing mutual fund, it is crucial for investors to adopt a more holistic and prudent approach to SIP investing. Instead of solely focusing on past performance, investors should consider a fund's long-term track record, consistency, risk profile, and alignment with their financial goals and risk tolerance.