Shall we try out the following experiment? Pick a fund that you invest in. Say Quantum Long Term Equity or PPFAS LTVF or HDFC Balanced. Enter all the transactions in that fund(s) in a portfolio tracker. Then add a couple of index mutual funds like Franklin Nifty Fund or ICICI Nifty Next 50 fund. Use the same transaction dates and if you wish the same amounts for the index funds.
If you invest further in any of your funds, you add the same amount on the same date as a transaction entry in the index funds. If you redeem, you redeem from the index funds. Suppose you keep this up for 5Y, Maybe 7Y, 10Y or even 15Y.
After a "long enough" time if you compare the returns and corpus value and find that the index fund(s) have beat "your" funds, would you feel disappointed? Would you think, "I wasted all that money on expense ratio, only to get lower returns!" Would you regret your choices?
It is human to feel at least bit upset about such a result. However, that is only a slice of the story. Which brings me to ask, are you an amazon customer or an amazon delivery guy?
What does the Amazon customer do? They go to an amazon product page and place an order. They see the expected delivery date and expect the product on that date. They are involved at the end points - the start (add to cart and buy) and the end (receiving the product).
Most of us are amazon customers when it comes to investing. We invest in something and expect it to deliver when we need the money. This is the kind of brainwashing that the financial services engage in. Often because they are brainwashed into believing that it is a noble cause to make investors feel that way.
Investors are to blame too. They think that just because they have invested in equity, they expect it to "deliver over the long term". They tell themselves, "ups and downs do not matter. My goals is years away"
There is a common explicit or implicit assumption involved in equity investing: despite ups and downs, the index will always move up, given enough time.
This is identical to what an amazon customer does. Buy a product and expect it to be delivered at said date. We don't worry about how the package will be shipped, what route it will take and so on. There is nothing wrong with that expectation because we have paid for the delivery. Even if the package is all squished up, it is a simple matter to get it replaced. If the goods are lost or damaged in transit, amazon will claim insurance and replace them for you at the cost of a delay. Sure there will be a blip or two, an unsatisfied customer here and there, but it is a reasonably robust and trusted process.
Investing cannot be done this way. No financial instrument, including fixed deposits, come with any kind of guarantee that they would give you the money you need when you need it.
Now let us put ourselves in the shoes of the delivery guy or delivery provider as Amazon calls it. They will have to figure out a cost efficient and resource efficient way of delivering packages and they need to worry about road safety (accidents do happen. Google - "amazon delivery accident"), For them the process matters - how and when they deliver.
An active mutual fund manager is (expected to behave) like a responsible delivery provider.
Unlike what most investors believe, an active mutual fund managers job is not to get higher returns than a benchmark. This often involves taking more risk and it could backfire. The active fund managers job is to enhance returns for a reasonable level of risk. See: What is the role of a fund manager?
On a rainy day, would you be eager to receive a soggy package or be happy that it was delivered a day late, but dry? Investing in market linked securities is not very different. A fund that consistently falls less than an index is more valuable than a fund consistently rises more than an index.
Some people discard this idea in terms of "risk appetite", saying, "I have high-risk appetite and can handle ups and downs". Simple common sense dictates that whether we have a high, low or medium appetite for risk, none of us can really afford a loss close to when we need the money. This means that we all think in terms of delivery providers.
As you may know, I had recently conducted a comparison of 235 equity mutual funds with the Nifty Next 50. These were from Value Research's
- Small Cap
Categories. For durations above 3Y, none of the 235 funds had ("on average") lost more than nifty next 50 when monthly returns were considered for the last 4,5,6,7,8,9 Y periods. This is known as downside protection and is calculated in terms of the downside capture ratio. Read more: Understanding Upside and Downside Capture ratios.
Over 3Y, 19 of the 67 multi-cap funds had a poor downside protection than the Nifty Next 50. Only a handful of funds in the other categories had a similar stat.
If (and that is a big IF), one must compare the performance of funds in the above category with the nifty next 50 (only because it has done well), I think active fund manager have taken care of downside protection quite well. Most of them have been efficient delivery providers and we as customers must recognise it.
Risk management does not end with the fund manager for the investor. Whether we invest in an index fund or an active fund, we still need to have a specific asset allocation and change it systematically (once a year, say) or conditionally (following moving averages or PE etc.). Risk management may or may not result in better returns. That can only determine in hindsight. The main aim of risk management is to keep us calm in real time.
As for, "ups and downs do not matter. My goals is years away", yes, ups and downs over days or weeks do not matter for a goal that is years away. However, ups and downs over a year or maybe two, do matter. There must be a strategy in place to minimise such risks.
We need to be both a customer and delivery provider.
As a customer, we need to choose products in the right proportion that suit our goals: Deciding on asset allocation for a financial goal
Then we put on the delivery providers cap and adopt some simple Steps to De-risk our Investment Portfolio. Only then can we take delivery.
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