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Conventional Investment Wisdom: Follow Cautiously

| 5/3/2012 9:00 PM Thursday

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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