Did you get lured by Past Performance?

Did you get lured by Past Performance?

In the bustling world of finance, individuals like Kavita, a career-oriented woman employed at a prominent IT firm, aim to leverage their tech-savvy backgrounds by actively utilising digital platforms. Kavita meticulously oversees her portfolio, comprising stocks, bonds, mutual funds, and more. Her strategy involves relying on her brokerage platform for stock insights and various online resources such as Value Research, MoneyControl, and ET Online for mutual fund decisions. Her ultimate goal is financial independence, which is a shared aspiration among countless individuals. The pertinent question we must ponder is, "What guides the majority when it comes to making investment choices?"

Let's zero in on the mutual funds sector, where there exist over 500 Equity Funds in the country from about 47 mutual fund houses. Notably, both investors and research agencies frequently base their decisions on historical data. Agencies like ValueResearch assess long-term parameters and assign star ratings to funds.

However, it's vital to consider the cautionary phrase often found in investment communications: "Past performance is not an indicator of future performance." Have you ever stopped to reflect on the reasons behind this? Allow me to explain with an illustrative example:

Example 1

Consider this data comparing the performance of large-cap funds over two distinct three-year periods. The top performers during the initial evaluation period did not sustain their success in the subsequent performance period. In fact, the top performer from the evaluation phase ended up at the bottom during the subsequent three years. This data reveals that making investment decisions solely based on historical returns may not be the wisest approach. Even within the same investment category, substantial disparities in fund performance are evident. This raises a critical question: why does this happen? If past performance isn't the ideal metric, how should one choose a fund?

Pitfalls of Chasing Winners

Exhibit 1: Fund Return - Large Caps

Source: Ace Mutual Funds

Before delving into that question, let's explore the significant variations in performance across different funds. We analysed all the Large Cap mutual funds, focusing on their 1-year returns. Remarkably, these funds invest in the Top 100 companies by market capitalization – firms most of us can easily name.

Exhibit 2: Large Cap Universe - Last 1 Year

Source: Ace Mutual Funds

The table underscores the striking differences in performance among these funds. If you happen to select a fund that ends up at the bottom, the disparities are too substantial to ignore.

The "Recency Bias" isn't confined to mutual funds; it permeates various investment decisions, including equity shares for both short and long-term investments. This cognitive bias is one of the most prevalent in behavioural finance, where recent events significantly sway investment choices. For instance, positive market trends boost confidence and investment, while negative trends elicit fear, causing many investors to buy during bullish phases.

Example 2

The chart below vividly illustrates how retail investors are often ensnared by the "Temptation of Past Performance. In 2022, Adani stocks experienced a meteoric rise, luring retail investors with promises of continued success. Sadly, this euphoria was short-lived, and investors faced substantial losses. This narrative serves as a reminder that relying solely on past performance is perilous.

Exhibit 3: Adani Green-Retail Investors Trapped by Volume and Price Data

Source: TradingView

FOMO (Fear of Missing Out) investing is when people make money choices because they're scared of missing out on good chances in the financial world. They might follow the crowd and invest in trendy things even if it doesn't make sense for their usual plans. This is like recency bias, where folks pay too much attention to what's happening right now and ignore the past. They both can lead to hasty decisions and risks because you don't think about the long-term picture, and that's not always good for your money.

Exhibit4: IPO Table - Biggest IPOs in last 2 years since performance since listing

Source: Bloomberg, SEBI

This underscores the paramount importance of a well-informed fund selection process. Instead of relying solely on past performance, a comprehensive fundamental analysis is imperative, considering factors beyond historical returns, for a prudent and diversified investment approach. While it's undeniable that a fund's performance track record provides valuable insights, it is only one piece of the puzzle. Selecting a mutual fund scheme necessitates a deeper understanding, considering factors such as:

  • Fund's portfolio composition

  • Track record of the fund manager

  • Investment processes

  • Fund Size

  • Portfolio Turnover

  • Sector and Stock weightings

  • Risk Assumptions

  • Diversification.

Investing is a complex journey. It necessitates time, effort, and skill. So, is it worth the risk? Many affluent investors rely on expert advice. While you may not be wealthy yet, smart choices can expedite your path to wealth.

Effective wealth management is an iterative process, not a one-time decision. Successful monitoring of your mutual funds is crucial. This doesn't mean reacting to every short-term fluctuation, but rather understanding the source of performance. Investing demands more profound analysis than merely glancing at past returns.

In conclusion, investing requires a comprehensive analysis, looking beyond the allure of past performance. To make informed choices and address the ever-changing market dynamics, professional guidance becomes paramount.

Ladderup Wealth since 2011 has broken the ranks and established itself as one of the most premier wealth management firms in the country. Your wealth is irreplacable and you have acquired it after decades of hard work. It is important that it is constantly monitored and nurtured with the right approach. You might not have the right time/skills to do it yourselves but we can help you on that journey. Improper and incompetent advice can have long term side effects on your wealth, so please choose wisely. Get in touch with us via our website today.