Very often, investors choose a fund based on somebody’s recommendation but later find that it doesn’t live up to their expectations and wonder if they should exit it. So, what is the criteria for selecting the right kind of products?
Most investors gather information from websites, newspapers, TV and find that certain investments have done well in the recent past, everybody is talking about it and then, based on such information, decide to follow the trend. That is herd mentality.
However, after a few years, they realize that these investments are not performing up to their expectations and then reshuffle their portfolio. They then invest in some other product that has been doing well lately and after a few years find out that the same story is repeated again. Why does this happen?
We encounter certain biases that we all have, the biggest of them being recency bias. You look at something recent and believe that it’s going to continue into the future. What’s the danger of doing that where it concerns our investments is the question to really answer.
The danger is something referred to as ‘breaking the sequence of return’ for your financial goal. Let’s assume that your goal is sending your daughter abroad for future studies. Say, that the goal is 10 years away and you would need ₹20 lakh for this purpose. Your adviser recommends you to invest approximately ₹10,000 per month in a few funds for 10 years which may help build this corpus, assuming a return of 10%.
As humans, we might desire to reach that goal in five years by chasing investments which we assume can deliver higher returns. So, you end up investing in high-risk investments and later realize that the portfolio is not doing so well or delivering negative returns. At this juncture, you reshuffle your portfolio again by adding certain investments that are currently popular or are trending and are being chased by many investors.
So, for instance, consider that you have invested ₹100 in a certain product. If that investment goes down to ₹50, it means that you’ve got a 50% loss. Now, you need to double this amount to get back your original investment, which means that you will need a 100% return .
This is what happens if you extend this over that 10-year goal and you have some investments yjsy you think are very good now but it delivers a negative return in the second or third year.
Indeed, equity funds can deliver negative returns. If you choose funds that have delivered double-digit returns in the recent past and invest in them, it is very likely that the very funds may give you low returns or negative returns.
If you are investing in products that you like and those funds deliver negative returns in the first couple of years, you will never be able to get back to that 10% compound annual growth rate, or CAGR, for 10 years that you require to get to your goal.
You may invest in funds you like but you should have a long term horizon. For long-term goals, you’ve have to be mindful of the sequence of return risk.
Let me tell you a riddle about lily pad. Imagine that there is a little pond which has a single lily pad or a lily leaf. Imagine that this pad doubles in size every day. The lily pad covers the whole pond in 20 days. At what point of these 20 days did the lily leaf actually cover half the pond? A lot of people are going to jump to the conclusion that it happened on the tenth day. If the lily pad doubles in size every day and it covers the whole pond on the 20th day, it covers half the pond on the 19th day. That’s the magic of compounding.
Sometimes, it’s human tendency to tinker with our investments just like we may want to replace our car or bike but the best approach is not to tinker with your portfolio once you have selected appropriate funds that are good enough to give you the return range you seek.
Here’s where a good trusted financial advisor can help you stick to your goals and the plan.
Ajit Menon is CEO, PGIM India Mutual Fund
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Updated: 15 Aug 2023, 10:50 PM IST