We still remember the story of tortoise and rabbit which we have listened so many times in our childhood and we still give reference of that story in our general life and we relate with it at times. The moral of the story was to be consistent. Tortoise was slow than rabbit but due to his consistency he reached first to the goal. This story much relates and suits to human behavior regarding investments in Mutual funds.
Why chasing higher returns would not help you?
People chase returns because they believe that is the only way they can achieve the financial goals, but sadly this is the wrong approach. Chasing the investment returns would neither achieve the higher portfolio return nor achievement of financial goals. This sounds counter intuitive at first glance, but it is not.
Let’s take an example:
Here’s a quick arithmetic test. What would be average returns of these TWO series of numbers:
- 40%,50%, -60%, and 65% (Answer: 23.5%)
- 20%,15%,17% and 20% (Answer: 18%)
Let’s say you are told the number represented the yearly average returns of two investment option, A and B over the past 4 years. You may be tempted to think that despite somewhat volatile nature of returns from A, that’s one which had given higher returns over the past 4 years. However, most important thing about the investment returns is that it is multiplicative not the additive. Hence, Average returns which we chase religiously, will give you absolute wrong answer in return calculations.
In the case of Investment, A 100 Rs invested at the beginning of four years would have values of Rs. 140, 210, 84, and 138.60 at the end of 1,2, 3 and 4 years respectively.
On the other hand, Investment B will have values of Rs. 120, 138, 161.46, and 193.75 at the end of 4th year.
This high school mathematics has an important lesson for investors like that we learnt from tortoise that consistency really matters not chasing the race like rabbit.
And with this example you have another lesson that 90% positive returns and 90% negative returns are not the same thing in investing. If you have made a positive 15% returns instead of 90%, you would take 4.6 years to grow your money by 90% instead of 1 years. This may not be such bad thing. While if you lost 90% in first year itself, it would take many years to just touch the break even. If you have started with 100Rs, and first year if your money got plummeted by 90% then you would be left with 10 Rs and getting back to 100 Rs that would take many years to grow your money with ten-fold.
This is the reason most investors don’t make money as they don’t stay invested and keep churning. The more they try to time the market, the more they lose.
So, what should you do …
One needs to invest when the asset is least fancied – that’s the way to make money. But investors do exactly the opposite. By regularly moving from one asset to the other, they also incur costs and taxation, which they rarely take into account. They also miss out on the most important aspect of why they are investing.
Getting the asset allocation right is important. Every asset will not perform at every point; but it offers diversification and provides a cushion when one asset under performs. We need to, hence, look at the overall portfolio returns – not individual asset returns and within that scheme-wise returns.
Investment returns are important and will come when invested properly. We have seen that most people can meet all their goals at a modest 9 percent portfolio return. So, investment returns are not what we need to focus on. Disciplined investment, proper asset allocation, and periodic reviews are what are needed to ensure that one’s life is well funded.