The temptation to switch to best-performing mutual fund is hard to resist. After all, who wouldn’t want higher returns? But this seemingly sensible decision can quietly eat into your long-term wealth.
Mutual fund investors are constantly bombarded with lists of top-performing funds. Social media, YouTube, WhatsApp, and investment platforms are filled with stories about schemes that have delivered stellar returns over the past year. It’s easy to look at these rankings and wonder whether your own fund is lagging behind.
Consequently, many investors begin to view their own portfolios through this same lens. If their fund isn’t on that list, they feel they might have made the wrong choice. They then sell their existing holdings to invest in the fund that performed best over the past year.
On the surface, this decision seems perfectly sensible.
Chasing funds that appear superior each year can often diminish your total wealth in the long run. The reason isn’t merely picking the wrong fund, the real culprit is the habit of frequently switching investments. This triggers tax liabilities, disrupts the power of compounding, and often causes investors to miss out on the market’s best rallies.
In other words, a decision made to boost earnings could end up shrinking a potential multi-crore rupee corpus years down the line.
Why do investors switch funds so frequently?
The primary reason lies in human psychology.
When a fund stays constantly in the news and its impressive returns are widely discussed, investors assume it will continue to be the top performer in the coming year. Conversely, if their own fund delivers lackluster returns for a while, anxiety sets in.
Gradually, comparisons begin. A friend made more money with a different fund. A website ranked another fund as number one. A YouTube expert recommended a new fund. Then comes the feeling that it is time to switch funds.
In reality, this decision is driven more by emotion than by investment logic. In investment terminology, this is known as ‘performance chasing’, that is, moving money to wherever recent returns have been high.
The problem is that in the world of mutual funds, there is no guarantee that last year’s winner will remain a winner the following year. The market is constantly changing; sometimes large-cap funds take the lead, while at other times, it is mid-cap or small-cap funds. Similarly, value stocks may outperform during certain periods, while growth stocks may do so at others.
This is precisely why basing investment decisions solely on the past year’s returns often proves costly.
It is not just taxes and exit loads; exiting the market at the wrong time can also prove costly
There is another major downside to frequently switching funds. Investors often attempt to time the market, but this is far more difficult than it appears.
It often happens that people panic when the market falls and sell their funds. Then, when the market surges, they reinvest. Consequently, they sell at a lower price and buy at a higher one.
As a result, the actual returns realized by many investors fall short of the fund’s declared returns.
Ankur Thakore, Chief Business Officer, HSBC Mutual Fund, says, “Psychology plays a big role in investment behaviour.”
According to him, “Frequently changing mutual funds can reduce your long-term returns because you may miss out on the power of compounding, pay exit loads and taxes each time you sell, and make timing mistakes by moving out when markets feel negative.”
In other words, the loss is often caused not by the fund itself, but by our own decisions.
The market has another distinct characteristic: its biggest rallies often occur when most investors are staying on the sidelines out of fear. If you frequently switch funds or exit your investments for periods of time, you miss out on the benefits of the market’s best days.
Ankur Thakore offers an interesting example to illustrate this point. He notes, “Missing only the best 5 days in the BSE Sensex over 18 years (2006–2024) reduced annual returns from about 14% to about 11%.”
He adds, “Since no one can reliably predict the best or worst days, staying invested for the long term is usually a simpler and more effective way to build wealth.”
Ultimately, the greatest benefit in investing often comes not from picking the perfect fund, but from staying invested over the long haul.
Often, it is the investor’s habits, not the fund itself, that erode returns.
Same fund, different investors, different returns
If two investors invest in the same fund on the same day, will they both earn the same return?
At first glance, the answer seems to be ‘yes’. However, reality is often different.
The reason for this lies in investor behavior.
Some investors panic as soon as the market falls. Others make new investments when they see a rally. Many investors switch every year to the fund that has recently performed the best.
Such decisions gradually impact overall returns.
Aditya Mulki, CEO of Navi AMC, says, “In many cases, investor behaviour has a greater impact on long-term outcomes than fund selection itself.”
He explains that there is a concept in the investment world known as the ‘investor return gap’. This means that the average return investors receive is lower than the return generated by the fund itself. The primary reason for this is not the fund, but the investors’ own decisions.
Mulki says, “Investors often add money after strong market rallies, reduce investments after corrections, or switch to whichever fund has recently topped the performance charts.”
This is why they often buy at high levels and sell during market downturns.
According to him, “The key lesson is that long-term discipline often matters more than finding the ‘perfect’ fund.”
In other words, rather than searching for a new fund every year, it is more important to remain patient with a good fund you have already chosen and give it time. This can prove to be the most effective path to building significant wealth over the long term.
Review your funds annually, but don’t switch them every year
There is a crucial point to understand here.
Regularly reviewing your mutual funds is a good habit. However, switching funds every year simply because you conducted a review is not a sound strategy. There is a significant difference between the two.
A review entails checking whether your fund is adhering to the investment strategy for which you originally selected it. Is its risk profile aligned with your goals? Is it still fulfilling its intended role within your portfolio?
However, if the review is based solely on the past year’s returns, the approach may be flawed.
Mulki says, “A one-year review is not too short; it simply answers a different question.”
According to him, the objective of an annual review should be to determine whether the fund is sticking to its stated investment strategy. It should also assess aspects such as risk management, portfolio construction, and how the fund has behaved across different market cycles.
Mulki adds, “The mistake is not reviewing a fund every year; it is treating a single year’s return as the final verdict on a strategy designed to compound over many years.”
He further advises, “A practical approach is to review your investments annually but evaluate long-term success over a full market cycle.”
In other words, keep an eye on your investments every year, but base your decisions on multi-year performance, the investment process, and your financial goals.
So, under what circumstances is it the right decision to switch mutual funds?
Switching funds is not always wrong, but there must be a compelling reason for doing so.
You might consider switching funds if there has been a fundamental change in the fund’s nature or if it no longer aligns with your investment objectives.
Ankur Thakore says, “An investor should consider switching a mutual fund only when something fundamental has changed, rather than reacting to short-term performance.” According to him, a review might be warranted if the fund’s objective has changed, there has been a significant shift in its investment process or philosophy, or if it has consistently underperformed its benchmark and peers for two to three years.
Mulki echoes this sentiment. He states, “Not every period of underperformance is a reason to replace a fund.”
He notes that there are other circumstances where an investor should reconsider their decision, such as a major change in the fund manager, a shift in investment style, holding multiple funds with similar portfolios, or changes in the investor’s own financial goals and risk appetite.
On the other hand, switching funds simply because another fund has delivered higher returns over the past year is not considered a valid reason.
Ankur Thakore clearly advises, “Stay aligned to your risk profile and goals.”
Meanwhile, Mulki offers a simple yardstick for investors: “Before replacing a fund, ask yourself whether you can explain the reason without referring to recent returns.”
If you lack a concrete reason beyond the past year’s returns, your decision might be driven more by emotion than by a sound understanding of investment principles.
Ask yourself these 7 questions before switching funds
If you ever feel the urge to switch mutual funds, make sure to ask yourself a few questions before making the decision. Often, the answers themselves reveal whether a switch is actually necessary or if patience is all that is required.
- Has the fund’s investment objective changed?
- Has its investment process or style deviated from the original?
- Has the fund consistently underperformed its benchmark and peer-group funds for several years?
- Have my financial goals or risk appetite changed?
- Does my portfolio already contain multiple funds with nearly identical holdings?
- Do I want to switch funds simply because another fund has delivered higher returns over the past year?
- Have I accounted for the taxes and other costs associated with switching funds?
If the answer to most of these questions is ‘no,’ then switching funds based solely on returns could be a hasty decision.
Conclusion: A good investor isn’t one who hunts for a new fund every year, but one who sticks with the right fund
There are no shortcuts to success in mutual funds. Choosing the right fund and staying invested for the long term is far more important than trying to pick the top-performing fund each year.
Market fluctuations are inevitable. There will be years when your fund performs brilliantly, and others where it might appear average or weak.
However, switching funds at every market swing often works to the investor’s disadvantage.
Frequent switching adds to these costs and can cause you to miss out on significant market rallies, while patient investors can reap the full benefits of compounding over time.
That is why experts advise reviewing your portfolio regularly but making changes only when there is a solid, fundamental reason to do so. Past one-year returns alone do not determine a fund’s future prospects.
Ultimately, the key to long-term wealth creation is not switching funds at the right moment, but staying invested in the right fund for the long haul.
Disclaimer: This article is for informational and educational purposes only and should not be construed as investment advice or a recommendation to buy, sell or switch any mutual fund. Mutual fund investments are subject to market risks. Investors should evaluate their financial goals, risk appetite and investment horizon, or consult a qualified financial adviser before making investment decisions.
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