DSIJ Mindshare

Conventional Investment Wisdom: Follow Cautiously

Conventional investment wisdom and maxims need to be taken with a pinch of salt as they do not always translate into what they are meant to says Shashikant.

There are many concepts and theories under the investment realm on the basis of which an investor acts. For example, you will always find experts and commentators talk about how it is always better to diversify your investments or about how one should follow the herd as they believe in the maxim “trend is always your friend”. Are these wisdoms worth following blindly or should one check up on its validity before committing funds to an idea based on them? Here is a reality check.

Diversification helps to contain risk

This popular belief holds true on many a occasion and is specifically true when it comes to the ownership of just a few individual stocks and bonds. However, when it comes to mutual funds there are investors who have invested in various mutual fund schemes in the name of diversification and risk mitigation. Simply owning four different equity diversified funds does not mean that you have diversified your risk well. The reason is, there are only a few stocks that are found in every portfolio and in which a chunk of the net assets are invested.

For example, if we analyse the holding of the top performing schemes (five star rated by a popular mutual fund website) there are some stocks like Tata steel, Wipro, HDFC Bank, Bajaj Auto etc which are found invariably in every scheme. So what this means is, even if you are investing in the top performing schemes it is no guarantee that in a bad year your return will outperform the market because most of the stocks are common and in all probability will move in the same direction. The logic can be extended to other sector funds too. Hence it makes sense to invest in a couple of funds rather than go in for a larger diversification.

Consistency in performance always pays

This seems to be one of the most popular belief on the basis of which investors make their investment decisions. Whether in case of individual securities or whether in case of funds, investors do give this maxim a thought before committing their funds to them. That advice may have intuitive appeal, but it ignores a couple of key facts. For one thing, good luck and the vagaries of the time period taken to calculate such returns can shape a fund’s “consistency” just as much as investment merit can.

stopclockFor example if we look at the return generated by some funds taking different time periods, their performance might not look consistent. Look at JM Basic, a mutual fund scheme. The scheme generated an eight per cent return between April 2007 and January 2008. However, if we extend our study period to 12 months the return falls by half to four per cent. Similar examples can be found, where tweaking of time periods may change the “consistency” in performance of the fund. One of the reasons for such a difference is, the best investments, whether stocks or funds, tend to be somewhat “lumpy” in terms of their performance. Their fortunes may ebb and flow from year to year or month to month. Therefore if you have a long term investment horizon it does not make sense to focus disproportionately on a year-to-year or quarter-to-quarter performance. Looking at consistency of absolute returns--that is, a fund’s ability to avoid real losses--is a more worthwhile exercise, particularly for investors who are close to tapping their assets.

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Sell underperformers

It is true that all investment decisions should have a sensible “sell” strategy in place, however such a sell strategy entirely on the basis of market performance does not hold well for good investments. It can work for mediocre or rather bad investment calls. The funds that have been poor performers for several years in the running may be fundamentally flawed and might never recover. In such instances, it is always better to sell and cut your losses.

However, in the case of good investments, a weak performance period may actually be an occasion to add to your holdings. This is best exemplified during the period of 2001-02 and more recently during the post subprime crisis. Most of the good funds would have had a long run of bad performance, even compared to the broader market, other sectors and within categories too during this period. If you sell at such a time it means that you have been paying attention to the market’s opinion without bothering to consider the underlying attributes of the funds you were selling. Therefore as an investor you should have the stomach to absorb the notional losses and to buck current market sentiment and stick to your losers as long as the investment thesis for your fund remains intact.

Cash is king during volatile times

It has been observed that during volatile time’s investors tend to mess up with their investments by buying and selling at inopportune times. One should invest only after knowing his risk appetite. However, risk tolerance should not feature right on top of the pecking order while making investment decisions. Priorities should be given to other considerations like time horizon, asset allocation, your savings rate, and the expected returns from various asset classes in determining your funds. Moreover, paying too much attention to your risk tolerance could leave you with an ever-changing asset allocation. At times when you are confident about the market you are inclined to take additional risk, while at other times when you are feeling bearish, you might sell your good investments too. If ever there were a recipe for poor investment returns, it would be this.

To be more specific when the market turns bearish and everything is south bound as we witnessed during the dotcom bust of 2000 or in 2008 and early 2009 a rational decision at that point of time would have been to shifting into cash and shield your portfolio from losses. But such relief is very short lived as we have witnessed during 2003-2007. That period was one of the best for the Indian equity market. But remember that after seeing low in March 2009 the market nearly doubled in the next nine months. Therefore even though you tend to protect yourself from losses during such downturns, the dilemma that really could haunt you is, when to enter the market again? Moreover, if you lose out on some really good rallies in the market, you are likely to miss out an opportunity of major capital appreciation. Therefore if you have cash requirement in the short term it makes sense to cash out quickly but if you’re investing with a faraway goal in mind, your best bet is to stay invested and do not let short term fluctuations ruin your returns.

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