By Pratik Oswal
With hundreds and thousands of mutual funds out there, high returns become the default filter. Buying a mutual fund is equivalent to trying to decide between 1,000 different hair dryers. The best decision is to buy a decent one and stick to it for a very long time. But investors keep on buying the best hair dryer and sell the worst hair dryer. They don’t understand that juggling hair dryers is more damaging over the long run. Every hair dryer goes through good and bad performance over a longer time span.
If returns are the first filter for investors, the next filter tends to be star ratings. Very rarely will investors see a good performing fund with a bad rating. Unfortunately, ratings also tend to follow good performance, so investors are back to square one. In fact, in many cases, rating upgrades tend to happen after a period of good performance. This again is a type of return-chasing behaviour.
Reversion to mean
A lot of studies show mean reversion in the investment industry as well. By definition, mean reversion is a theory that suggests that asset prices tend to revert to an average level over a long enough point in time. This theory also suggests that investors following the opposite of return chasing should ideally make more money, i.e., sell good performing investments and buy poor performing investments.
In technical terms, this means ‘portfolio rebalancing’ and yes, it works wonders and forms the basis of intelligent investment management. Unfortunately, many investors do the opposite of rebalancing— buy more of good performing funds by selling poor-performing funds.
If an advisor sells a good performing fund and it does not perform, then it’s technically the fund’s fault. If he sells a poorly performing fund which then delivers poor returns, then that is the advisor’s fault. If someone advises Infosys as a stock recommendation and if the company underperforms, something is probably wrong with Infosys. But if an analyst recommends a small-cap stock, then it is the analyst’s fault. Investing in under-performing managers and selling strong performers may end up being a good strategy but comes with significant career risk.
Advisors and investors are not judged by the quality of their decisions but by their investment outcomes. A good decision going sour is a sign of poor decision making. A wrong decision with a little bit of luck is a sign of superior decision making. Good performers talk about their investing prowess, and low performers speak about bad luck. Not many talk about their investing process and frameworks.
FOMO (fear of missing out)
This one is relatively self-explanatory. It’s the reason why equity flows tend to be highest at market peaks. Fear of short term loss (FOSTL) is the reason why nobody invests during market bottoms. Overall, FOMO and FOSTL lead to poor long-term investment outcomes.
The writer is head, Passive Funds, Motilal Oswal AMC