Behaviour of capital markets is, more often than not, unpredictable and economists have developed complex concepts, trying to explain the behaviour of capital markets. These concepts often leave retail investors confused. In Advisorkhoj, our endeavour is always to simplify investments for retail investors, so that they can understand the nuances of investing and make the best investment decisions for themselves. However, I have observed that, over the past few years, there is a growing cultural trend towards oversimplification, not just in the world of capital markets and investments, but towards a variety of political, social and economic opinions. A veteran of US mutual funds, who I consider as one of my management gurus, told me many years back that, “Over complication is the refuge of the intellectually confused and over simplification is the refuge of the intellectually lazy.” While I am all for simplification because it leads to clarity of thought, there are dangers in oversimplification, which investors must recognize.
The biggest danger of over simplification is it leads investors to believe in the rhetoric and ignore their own investment needs. Your own investment needs is the most important factor in your investment planning process. Let me explain this with the help of an example. We hear all the time that, diversification is great, but if you are a 75 year old investor with no risk tolerance, should you really be diversified at all? The problem of oversimplification, which more often than not, borders on rhetorical is that, it pays no heed to reality. Consider this popular rhetoric; buy and hold will create wealth in the long term. Warren Buffet created huge wealth for himself and for Berkshire Hathaway shareholders through “buy and hold” strategy. This is great strategy in theory, but it may not work in reality. Just ask yourself, “Are you Warren Buffet”? If you are investing through mutual funds, ask yourself, “Is your fund manager Warren Buffet”? If you have followed Indian share markets over the last 10 years or so, you should know that, there a number of stocks, which are still trading below their, end of 2007, all time high. In this blog post, we will discuss some common oversimplified investment mantras.
Many readers would have heard of the risk return relationship. What this implies is that riskier asset class can potentially generate higher returns. What it does not mean is that a riskier asset will always give higher returns than a less risky asset. If it did, it would not be a risky asset. A recent retiree and new mutual fund investor, living in my apartment block, invested in equity mutual funds at the end of 2014, hoping to get higher returns than fixed deposit interest. When the market went through a downturn 2015 and the investor got lower returns, he got disappointed and exited his investments. The market has rallied more than 20%, since the investor redeemed his units, leaving him even more disappointed. Readers should know that the risk return relationship is a foundational theory of finance and investments. In this example, the theory did not fail the investor; it was the lack of understanding of the concept of risk which failed him.
Oversimplification sometimes leads investors to ignore important factors like market dynamics, fund manager’s alpha etc. For example, midcap stocks and funds are more risky than large cap stocks and funds. Yet in 2015, when we had a fairly deep correction, midcap funds, on an average, gave higher returns than large cap funds (midcap fund category average 2015 return was 6% versus -2% for large cap funds). The reason for the midcap outperformance of midcap funds versus large cap funds in market correction was the market dynamics in Indian equity market.
Indian equity market is dominated by FIIs, who invest mostly in large cap stocks. In a correction triggered by global risk factors, therefore, large cap funds are more susceptible to corrections than midcap funds. We cannot ignore market dynamics, when investing in equity, unless it is over a very long investment horizon. Oversimplification can lead investors to believe that, all mutual funds in a particular risk category are the same. In reality, there is usually a big difference in returns from mutual funds in the same risk category.
A good mutual fund gives better return than others for the same amount of risk. One of the measures of risk adjusted returns is Sharpe Ratio, which is the ratio of excess over risk free returns and the standard deviation of returns. A more effective measure of a fund manager’s ability to give superior returns is alpha, which in very simple terms, is the measure of the excess risk adjusted return given by the fund manager relative to a suitable benchmark. If you educate yourself about the nuances of investing and understand market dynamics you can be a much better investor.
How Warren Buffet created wealth for Berkshire Hathaway shareholders by buying and holding shares of companies like IBM, Coca Cola and American Express over a long period of time has become part of investment folklore. However, it takes special skills to identify good stocks that can give multi-bagger returns in the long term. Over the past ten years or so, while there have been wealth creating stocks, there also have been many wealth destroying stocks.
We will not discuss individual names, but a number of prominent stocks (many of them in the real estate space) have fallen 80% or more from their 2008 high. Buying and holding such shares would have been disastrous for investors. The Sensex and Nifty are at much higher levels than their 2007 / early 2008 highs, but there are stocks in Sensex and Nifty which are still trading below their 2007 / early 2008 highs. If you bought those stocks in 2007 and are still holding it, you would not have been very pleased with the outcome.
While you need to have a long term investment horizon when investing in equities, you should not be oblivious to market realities. The same applies to mutual funds. For example, certain types of debt funds and thematic equity funds do well only in specific market conditions. As soon as market conditions change, you should exit these funds. Even in diversified equity funds you should monitor the performance of your fund relative to the benchmark and peers on a regular basis. Some equity mutual funds did very well in the 2000 to 2007 period. Many of those funds are no longer top performers. There can be number of reasons why an erstwhile top performing fund fails to maintain its performance relative to its peers. Changes in fund management team, investment style and process may be contributing factors. However, you should not exit a fund based on short term performance only. You should try to understand, why the fund has failed to give good returns and then make a decision.
This is another oversimplified narrative, bordering on rhetorical. The problem with this rhetoric is that, it ignores an investor’s personal financial situation and when taken to an extreme, market realities, as well. A Kolkata based financial advisor told me that, he convinced a client on the benefits of Systematic Investment Plan (SIP); not that the client would have needed a lot of convincing, because the benefits of SIP has been plastered all over the digital media. Do not get me wrong; I believe that, SIP is one of the best modes of investment for a variety of reasons that I have explained a number of times in my blogs. But let me give you this example, where oversimplification is taken to its extreme, detrimental to financial interest of the investor.
So this client of the Kolkata advisor, I was talking about, was convinced about the benefits of SIP so much so that, even though he had a chuck of money that he wanted to invest in equity mutual funds about 8 – 9 months back, he invested the money in liquid funds and transferred it to equity funds of his choice through monthly Systematic Transfer Plan (STP).
8 – 9 months back investing through STP would not have been a bad idea, because we were expecting the market to be volatile for a period of time back then and therefore, this financial advisor was correct in recommending STP to his client. The problem is that, when you start believing in rhetoric, you start ignoring reality. Capital market is dynamic and not subservient to rhetoric.
From March to late August, the market rallied 25%; on an average 4% rise every month, while the investor continued his STP, implying that, the investor was buying units of equity funds at approximately 4% higher price every month. The investor would have lost a considerable amount of returns due his and his advisor’s insistence on STP. I asked this advisor, why did he not advise his clients to switch from liquid funds to equity funds, once it was clear that the market was in an uptrend? The advisor said that, “the market rose too fast too soon”. No, not correct.
The market has been rising for the last 6 months; 6 months is not too soon, especially in capital markets. I would blame the advisor more than the investor for the opportunity loss due to which the investor suffered. My guess is that, since the advisor recommended STP to his client 8 -9 months back, anticipating a prolonged period of volatility, his ego prevented him from recommending an alternative course of action for the investor. But I blame the investor also, because oversimplification led him to ignore the trend, which is obvious in the last 4 – 5 months.
Your investment decision should be based on your personal financial situation and your investment needs. Lump sum versus SIP is like comparing apples and oranges; they are not comparable at all. If you have lump sum funds to invest, keeping it in a bank account and investing through SIP is not necessarily the best mode of investing. If you anticipate a period of high volatility, it may be a wise idea to invest in low risk funds like liquid funds and invest through STP, but then you need to be nimble footed enough to know the transitions in market conditions and take appropriate actions. On the other, you should invest a portion of your monthly savings through SIPs for your long term investment goal.
It is true that, diversification reduces portfolio risks. But if you have no risk capacity, then you should invest in risk free or very low risk fixed income assets. Diversifying to other asset classes will increase your risk. On the other hand, if you are young and have very high risk capacity, you should simply stick to equity for your long term investment goals. Within equity you can diversify into different sectors, market cap segments etc.
Diversified equity mutual funds are constructed as diversified portfolio of stocks, across sectors and market cap segments. However, many investors and financial advisors take the diversification benefits narrative to an extreme and over-diversify by investing in a large number of mutual fund schemes. Over-diversification such as this does not reduce portfolio risks and can cause the investor to lose performance in the long term, not to mention the added work involved to monitor multiple schemes for no great benefit.
So far, we have discussed 4 oversimplified investment mantras. I would like to tell readers that, I conceptually agree with the basic idea of all the 4 mantras; what I have a problem with, is the oversimplification of these mantras. Like the previous four mantras, I am in complete agreement with the long term aspect of equity investing. However, the problem is in the lack of clarity in understanding.
Let me ask you, “What does long term mean to you in years?” Now you ask the same question to 5 acquaintances. It is more like than not, that you will get 3 – 4 different answers. The problem is that, it is a matter of interpretation.
For me long term is anything more than 3 to 5 years. For you, long term may mean at least 10 years. Even though you and I may differ on this, both of us are right. What is wrong is the subjectivity involved in the definition of long term, which can result in sub-optimal decisions. 3 to 10 years, in my opinion, is vast range. A very knowledgeable and successful New Delhi based stock broker once told me that, “investors should always hold an investment for at least 10 years, when they are investing in equities”. I asked him, whether this applied to direct equity investing or mutual funds as well? He told me that, it applied to both.
If I take the literal interpretation of what he said, it means that equity investments, including mutual funds, will not give good returns in 3, 5 or 7 years; I have to hold them for at least 10 years! In other words, if my investment horizon is, say 5 years, I should not be investing in equities at all! If I simply go by trailing returns given by top diversified equity funds over the last 3 – 5 years (please see returns of top performing diversified equity funds in our MF Research Centre), top performing funds have given fabulous returns in the last 3 to 5 years.
In my opinion, for investors with high risk appetites, equity as an asset class can meet a variety of investment goals, even over 3 to 5 years timeframes. However, depending on the nature of the goal and length of investment period, hybrid mutual funds combining both equity and fixed income asset classes, e.g. balanced funds, offer excellent investment choices to investors. Over the last 3 to 5 years, balanced funds as a category gave 14 – 20% average returns, multiple times higher than what investors would get from risk free fixed income investments. Going back to what the stock broker told me, I think, what he meant was that, equity investments give the best results over a 10 year+ investment horizon. However, the language he used, lends itself to oversimplification and the sub-optimal results thereof.
In this blog post, we have discussed the dangers of over-simplification in investing. As discussed earlier, the conceptual framework of the different investment mantras is very robust, it is the oversimplification (words in italics in the section headings), which is the problem. When applying these concepts in your investments, it should always be in the context of your own investment goals. Oversimplification may be easy, but will not give you the best results. You should educate yourself about the various financial concepts involved in investing and you will get the best results from your investments.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Dwaipayan leads content production and mutual fund research in Advisorkhoj.com. He is actively involved in business development strategy, driving revenue growth and profitability, delivering superior customer satisfaction and talent development in Advisorkhoj. An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with nearly 17 years of management and consulting experience in financial services domain across several geographies. In his previous corporate role, Dwaipayan was the Chief Financial Officer of American Express Global Business Services in India. He also co-founded a boutique consulting start-up to advice companies on business restructuring initiatives like private equity funding, mergers & acquisitions, divestitures, outsourcing and organizational restructuring. Dwaipayan has a strong track record of driving superior financial performance and developing talent in the organizations he has been involved with. He can be followed on his Twitter handle @DBadvisorkhoj.
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