There is a subtle difference between the returns of the fund you invest in and the returns you, as an investor, get from the fund. And no, we are not talking about taxation, but about a relevant concept for understanding investments.
All the experts and advisors will tell you that when you analyze a fund and look at historical returns as a metric, you shouldn’t rely on one-month or one-year returns for your decision. You should be looking at a performance over 10 or 15 years. The reason is that a relatively short period of time may not reveal the true and correct picture of this investment. It can be distorted by strong market fluctuations or phases of good and bad performance by the manager. In other words, a long period of time is needed to measure, minus the distortions.
Now let’s move on from the fund to you, the investor. If it takes a long time to realistically assess the performance of a fund, say 10 or 15 years, why shouldn’t it be the same for you as an investor?
You stay invested in the fund for, say, two years and exit for reasons such as personal cash flow needs, a market correction, or a perceived better investment opportunity.
Whatever your reason for leaving, your returns over a shorter investment horizon depend on how the market has developed over that time. While your returns over a longer time frame are also a function of market movements, market cycles do unfold and things balance out over a long horizon. Unless there is a significant bullish or bearish rally at the time of your exit, for a long-standing investment, the impact of current events on returns is not material. In the short term, during the period that you remain invested, your returns may be higher or lower than the long-term average for this instrument/investment vehicle.
matter of luck
While this is a factor of general market movement which is a big factor in determining returns, it is also a matter of luck, in a crude sense. In the mutual fund industry, there are funds that have completed two decades of existence, and the annualized rates of return to date are impressive.
This is due to the positive effect of capitalization over a long period and the growth of the market along with that of the economy.
To note, compound profit is a very powerful tool in investments, but for the real profit to materialize, you need to give it a substantial amount of time.
For example, if you hold an investment for, say, three years, the benefit of compounding your returns, apart from market movements, is limited. If you hold it for 15 years, the benefit is significant. In the context of the mutual fund data we mentioned, this shows that the number of investors who have stayed the course, from fund launch or shortly after launch to date, is surprisingly low. . More investors exited after, say, two or four years. The point here is that an investor who entered the fund midway through and exited after 2 to 4 years, say two or four years, is not going to get the same return that we see in the data of annualized return since inception to date.
So much for the assumption that you have to stay the course to get the same returns as a fund’s long-term historical performance.
Now, to understand, why does this happen? Here, we need to distinguish between a contract-return investment, such as a bank term deposit, and a market-linked investment, such as an equity-focused mutual fund. The market by nature is uncertain, experiencing cycles of ups and downs; but as long as the fundamentals are intact, it offers returns over a long period.
No one can predict market movements over a short period of time, and even here one year is a short horizon.
So why do people try to take advantage of market movement over, say, one or two years?
When prices rally, everything looks bright, and people come in with fresh money hoping to take advantage of the rally, trying what is called “catching momentum”. If you’re leaving due to cash flow needs, that’s another issue.
However, if you’re walking away from an investment that was meant to be long-term because you think it’s not yielding as much return as expected, it’s best to seek the professional advice of a financial advisor.
If you’re walking away because there’s a better investment opportunity, you need to be convinced why the new opportunity is better and that you’re not trying to grab the other’s momentum.
So what if you don’t have a 10-20 ten or twenty year horizon? There are many types of possible investments. There are defensive investments, which you can opt for, on a shorter horizon; these last from a few days to a few months or a few years.
There are mutual fund schemes, term bank deposits, corporate deposits, bonds, etc. You can choose the one that suits your investment horizon.
In behavioral finance, the difference between ROI and ROI is known as the behavioral gap, which is a perceived dynamism on the part of the investor. Equity-focused mutual funds, which have been around for a long time and show attractive returns, need to be put into perspective.
If only a smaller percentage of investors had exited, it was understandable that most people would have profited.
Since only a tiny fraction of investors have stayed the course and actually taken advantage of the returns, it has to be seen in this light. This is also a lesson for other investors; from a global point of view, a greater number of investors should benefit from the evolution of the market.
(The author is a corporate trainer and author)