There are several mutual fund investors who keep switching schemes to receive better returns. But switching isn't always a good idea because it can worsen the situation. It may seem like smart portfolio management, but it is actually an expensive habit. This is something that can quietly chip away at your wealth, which is meant to grow. Therefore, the following blog sheds light on why switching mutual fund investments frequently leads to significant losses.
The Behavioral Trap
The returns obtained by the recent investment often act as a pathway to how future performance will be. Such a phase is termed recency bias, and it leads to millions of switching investment decisions every year. There is a sudden surge in inflow when a scheme keeps coming at the top for 1 to 2 years. So, the investors assume that this momentum will continue and start to ignore the actual market cycle rotation and the current winners. Thus, resulting in a laggard result in the future.
According to the reports of AMFI and SEMI, the top quartile funds don’t always stay on top for consecutive years. Still, the behavioral finance studies show that investors go through fear of missing out (FOMO) and ignore logical investments. Therefore, such a chase-and-switch cycle encourages investors to purchase more costly funds before they start outperforming in the market.
Hidden Transaction Costs & Exit Loads
Switching mutual fund investment plans doesn’t always come for free; rather, some of them charge an exit fee in case the units are redeemed before a holding period. The charge can be 1% for the withdrawal process when it is done within 12 months. This 1% might look too low, but the compounding process can be a real drag when the investor chooses to switch every year. For example, on a ₹5 lakh return, the repeated exit can reduce the amount by thousands of rupees over a decade.
Other than the exit fees, the investors might also end up ignoring the Securities Transaction Tax (STT), bid-ask spread inefficiencies within the underlying portfolio, and the addition of a higher expense ratio structure for the new funds. Such schemes can be more competitive than the previous ones.
The Tax Bite: Capital Gains After the Switch
Frequently switching mutual fund investment plans is treated as redemption by the tax authorities and not just a simple transfer. Such a process can trigger capital gains taxes, even after you choose to reinvest the money into a different scheme.
When you choose to invest in an equity fund, the gains you receive within 12 months result in Short-Term Capital Gains (STCG) tax, which is around 20%. On the other hand, the units you hold for a long time can trigger Long-Term Capital Gains (LTCG) tax, which is around 12.5% on gains. This amount can be more than ₹1.25 lakh in a financial year, as explained by the current rules.
Conclusion
To sum up, frequently switching mutual fund investment schemes leads to costly errors. So, the main things that can increase your wealth over time are discipline, patience, and a long-term decision-making process based on market performance.
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