Overconfidence in Equity Could Spell Trouble for Investors!

Published: October 5, 2023 at 6:00 am

It is clear from how many readers, particularly young earners, respond to freefincal content these days that they are overconfident about their equity investments. Especially investments in small cap funds, mid cap funds, etc., that have soared in recent months. This could spell trouble for their dreams.

I hate to break it to you, but there is no proof that long-term equity investing will always give you “good returns”. All those arguments about the economy growing and the equity market reflecting those returns are mere opinions peddled by sales guys, fanned by ignorant influencers and heightened to legend by naive and lazy investors.

Yes, equity offers a more than reasonable chance of beating inflation (not matching your expected return), but that does not mean it always will. Here is our research:

Before continuing, I would like to clarify that we are not against equity investing (close to 60% of my family’s net worth is in equity, and more than 80% is market-linked, thanks to mandatory NPS). We are only trying to caution against overconfidence in equity.

So many people today assume their excellent returns will never drop. If there is something that we can be sure of about the equity market, it is good times will end – My retirement equity MF portfolio return is 2.75% after 12 years!

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Sharp drops are usually preceded or succeeded by sharp highs due to an idea called volatility bunching. Read more: Timing the market will work but not how we imagined! The bigger problem is years of sideways markets.

This can happen due to economic slowdown, uncertain political climates, war, etc. We had such a “lost decade” in the nineties. In that decade, we did not have a stable government besides our economic difficulties (India was recovering from the brink of bankruptcy).

Can you be sure you will never encounter political uncertainty and poor economic growth in your investment journey?

There may be broad correspondence between economic growth and equity markets, but that does not mean it would be your specific experience. Besides, as the economy develops, equity markets become more stable, less volatile, and less rewarding. We already have enough evidence: Sensex at 50,000: lessons from the 42-year journey.

And what makes it worse is much of the long term returns of the past stories are based on just a few years! See: 44-year Sensex return is 17%, but half came from just four years!

As for the great small cap funds, there is no evidence investing in these will always get you spectacular returns. We simply do not have enough history of small cap funds, and whatever little we have, before 2018, when the SEBI MF categorization rules kicked in, many of these small cap funds held significant chunks of mid cap stocks. So, the long term returns of these funds are partly due to mid cap stocks —more about this in a detailed article. Also, see Nifty vs. Nifty Next 50 vs. Nifty Midcap 150 vs. Nifty Smallcap 250.

Being overconfident about the equity markets is probably among the worst investing mistakes we can commit. Equity is like fire. Fire is indispensable to our lives, but getting comfy and fooling around with it would burn you.

If there is one statement that we should take seriously about mutual funds, it is their disclaimer:

“A mutual fund scheme is NOT a DEPOSIT product and is not an obligation of, or guaranteed, or insured by the mutual fund or its AMC. Due to the nature of the underlying investments, the returns or the potential returns of a mutual fund product cannot be guaranteed. Historical performance, when presented, is purely for reference purposes and is not a guarantee of future results. Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully”. – Source: AMFI

While our long term goals require a good chunk of equity, our planning also needs a good dose of safety – reasonable inflation estimates, low return expectations from equity, asset allocation, diversification and an efficient de-risking strategy to achieve our goals regardless of future market conditions.

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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