Choosing Mutual funds on returns only is deadly

You have heard this often – Choosing mutual funds only on the basis of past returns can go wrong. Well, i have come to think of it more as a behavioural issue.

Take any investor, she wants the funds that do well. Past performance appears to be a safe indicator of what might come into the future.

It also comforts the mind. No one feels good about losing money, even temporarily.

But, how does it play out in real life?

I put together data for various investments across asset classes- primarily using indices or investment based on those indices.(actual names are not important)

Data Source: Investing.com

The upper part of the image shows past 12 month returns as at the end of the month in that column. The lower part shows the ranking as a heatmap.

Now, if you had decided to invest in Nifty 50 in April 2019 (greenest of the lot), you will be left disappointed. The no. 1 doesn’t remain so even over the next few years.

Yet, you get a annualised return of about 13%, if you just stick around.

If you are a gold lover, well, it ain’t a joy ride too. But over the 3 years, you got 17% annualised for staying invested.

Of course, this is all hindsight. Nifty did go down about 30% in March 2020 and so would your portfolio. Gold would have saved you then but not done much after.

In any case, you don’t put all your money in one basket.

So, maybe you pick 2 or 3 top performers instead of 1.

The question is for how long. You see the top performers keep changing and at some point, your portfolio will get a jolt of underperformance and you will get worried.

Unless you are mentally prepared for this scenario, doubts will take over and you will either abandon the portfolio or sell out at below average returns.

Is there a better way to do this?

Let’s try another way.

Say you and I were highly opportunistic and we will look at the top 3 ranked investments across asset classes (equity, bonds, REITs, Gold) in equal proportion and change once in a year.

That is, every 12 months, we change the portfolio to top 3 ranked investments then. What would be the result?

Let’s run the above strategy.

Period – from April 2016 to April 2022 (5 years)

SIP of Rs. 10,000 per month.

You will get some sense of the investment when you look at April 2019, April 2020 and April 2021 and April 2022.

With all the work, at the end of April 2022, your annualised return before costs and taxes is around 18%. I will let you decide if it was worth it. This was when our mix of investments allowed us opportunity to move around asset classes. For example, April 2019 was only Nifty 50, REITs and Gilt funds.

  • If you had decided to allocate only to the top 2 top performing ones (instead of 3), the result would be a tad higher at about 20% average returns.
  • Interestingly, if you decided to be adventurous and have entire allocation to the top ranked, you would have ended with about 16% returns.

Alternatively, a managed 60:40 (equity:others) portfolio could deliver about 17% during the same time period and with lower volatility (ups and downs). [Volatility is suffering]

Read more: How not to select mutual funds?

Choosing mutual funds for a portfolio – Is there a better way to do it?

There is always room for improvement. Now, chasing returns as we demonstrated above is in a way running with momentum. In a way, that’s what we were doing.

Simply put, the idea behind momentum is that a recently performing stock/fund should continue to perform in the near future too.

But, you need to follow through. It will have its suffering too, sometimes deep pain. You can’t escape that.

A diversified asset allocation model (like the 60:40 one) is likely to give you less suffering and work better for you. It also accounts for the fact that past is not the perfect guide for the future.

In summary, choose your suffering and you will have the reward.

And if you are willing to learn and implement to make your winning portfolio, then we are just getting started in our newsletter – “The LightHouse“.

Have you downloaded your free copy yet?

The next LightHouse edition will have a special feature.

Between you and me: How do you select your mutual funds? Do you have a secret recipe?

#Choosing #Mutual #funds #returns #deadly

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