Determine the result, ascertain its cause, assess the momentum to better predict performance

For all the talk, the pretence of knowledge, even the condescension she had got from her husband in terms of investment skill, she had beaten his pants off. Her investment had grown by 28%, whereas her husband had lost money. Here is the interesting part. Both had invested equal amounts of money and in the same scheme. The only difference was that the husband invested in February this year, whereas the wife invested in April. The husband had caught the crest of the wave, whereas the wife had caught the trough that followed a few months later. Was that skill or luck?

At the best of times, and armed with sophisticated attribution models, separating luck from skill in investment performance is difficult. Anyone who has invested across market cycles will know that some decisions that were backed by robust and thorough analysis suffered in comparison to other decisions that were made with the most cursory analysis. Having tracked the performance of mutual fund schemes and fund managers closely for 15 years, we have seen superstar fund managers from one era scrape the bottom of the barrel in another and vice-versa.

Yet, any endeavour of investing over the long term would be significantly hampered without an ability to analyze performance and draw the right conclusions. Here are some of the obvious questions that need to be addressed. First, the result—how well did your investment decisions fare? Second, the cause—how much of the result can be attributed to luck and how much to skill? Third, the “so what”—given the past, what should you do going forward? Let us look at each of these.

The result can be described in a few different ways. First, in rupees—how much money did you gain or lose? Second, as a percentage of the amount invested, or absolute return. Third, as a percentage after adjusting for time invested. Surely, a 20% return in one year is better than a 20% return in three years, right? This measure is usually called annualized return. Fourth, as a comparison to a benchmark. If one made 18% return where the benchmark made 20%, is that better than another making 16% where the benchmark made only 14%? Another way of looking at the same thing is to adjust the return for the amount of risk taken to achieve that return, something we refer to as the Greek letter alpha. We all need some measure of compensation for taking additional risk, often known as risk premium.

These measures do sound a bit like the blind men and the elephant, where they all came up with different assessments. Yet, people have many questions regarding their investments, and each measure above answers a different question. If you are looking to compare investment performance, using alpha and comparing against the benchmark are useful places to begin.

The cause is trickier, because here one needs to separate luck from skill. Timing is one of the reasons that can drive improper conclusions, as we have already seen. Further, when one is comparing two investment experiences, it is important to ensure it is an “apples to apples” comparison. Comparisons between fundamentally different instruments that are likely to behave differently are flawed, such as a mutual fund with a unit-linked insurance plan (Ulip), a hybrid scheme with an equity scheme, or a large-cap with a mid-cap. The third is to distinguish between consistency and “flash-in-the-pan” outcomes. Superior performance must be repeatable to be claimed as a skillset.

Finally, the “so-what”. To what extent can our conclusions from these comparisons be extended into the future? When is change necessary? If you are happy with the result, should you stay the course? If your results aren’t great, do you need to make changes? If our goal is to predict what will deliver superior returns in the year ahead, let us reflect on the inputs. While there are many factors, here are some to consider. The investor’s skill, whether it is regarding instrument selection, asset allocation or execution is likely to persist. The processes followed, whether they be research, investment or risk management, are also contributors. However, it is important to assess whether the investment environment has changed. If so, what worked in the past may not work in the future. Winners in a bull market are often different from winners in a flat market.

I recommend the above three-step process—determine the result, ascertain its cause, assess its momentum—as a way to achieve greater predictability in investment performance. At the very least, it will establish a lingua franca for its discussion.

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“To redeem or not to redeem is the question”

Check if redeeming can cause further losses in terms of exit loads or taxability

My seven-year old golden retriever, Leo, is a rather feisty dog. Walking him each morning is an exercise in physical and mental endurance. He constantly yanks his 30-kg frame on the harness, lunges at unsuspecting walkers in the hope of a friendly pat, flips out when he spots a feline or bovine, and marks his territory with dogged determination on every parked vehicle. The 45-minute walk from my home to the army grounds and back is all the callisthenics I need for the day. While everyone notices his rambunctious behaviour, few know that Leo has an uncanny sense of direction. No matter how far I walk him or through which unfamiliar route I take him, he will always lead me back home safely. In the process, I have become fitter too, just keeping up with his boundless energy.

Leo’s conduct is akin to how the market behaves in the short term. It stalls, lunges, plunges and behaves erratically most of the time. But over time, it leads you to your destination and delivers healthy returns. All you need is resilience and patience.

The job of a financial planner is to establish a strong visual for the future and then guide the client in achieving that vision in the most efficient manner. In this journey, there will be several instances of planner-client dissatisfaction because the journey to achieving the end goal is fraught with pitfalls and negative portfolio returns in the short term. Long-term goals that are several years away cannot be achieved unless the short-term pain is experienced. It is almost a rite of passage.

However, events like covid-19 cause clients to forget their long-term plans and make irrational decisions based on market noise. If you are paranoid about your portfolio and feel the urge to exit because of the market corrections, ask yourself these questions:

One, has only your portfolio corrected or has everyone’s? Most equity portfolios have eroded anywhere in the range of 10-30% depending on when you invested. Hence, this is a systemic risk, not unsystemic risk that only you are exposed to. Systemic risks are easier to overcome since they are usually addressed by regulators, government and central banks.

Two, did your portfolio fall steeper than the markets? This is unlikely if your portfolio has the right allocation between growth and safety. If your portfolio had only 50% allocation to equity, your overall dip will not be 30%, but far less.

Three, is all your money invested in equity? If so, you have a problem. You must set aside a part of your portfolio in safe assets even if you need to redeem now.

Four, do you have enough money to deal with short-term contingencies such as a job loss or pay cuts? If so, do not redeem from your equity portfolio. Use the money in the savings bank or liquid funds to deal with the contingency. If not, redeem from those equity assets with minimum tax impact and exit loads.

Five, would redeeming from your equity portfolio sacrifice a long-term return of 10% for a safer debt investment that has a post-tax return of 4-5%? Would you, thereby, jeopardize an otherwise inflation-beating portfolio by your actions? If yes, do not redeem.

Six, would redeeming the portfolio cause further losses on account of exit loads or taxes? If so, refrain from redeeming.

Seven, is a short-term goal approaching soon? If you have money in safe assets, redeem from there. If not, redeem from equity and secure the money.

Eight, what is your best-case scenario? If it is one where you hold on to your job, meet short-term goals comfortably, and continue your investments to meet your long-term goals, then stay true to your original investment plan and do not redeem.

Nine, what is your worst-case scenario? If you were to lose your job and have no income for some months, determine if you can still meet expenses comfortably from your contingency fund. If not, then liquidity is key, and you may need to redeem from equity to meet expenses.

Ten, have you covered your health and life risks adequately? If not, do so right away, so you are not forced to redeem at distress or loss.

Once you are clear about how you will approach the above situations, you will make the right decisions now and for the future.

One of the biggest challenges for investors is closing the gap between their own portfolio returns and the fund or market returns. Often market returns are higher than investor returns because of human behaviour. We end up investing when the markets are high and pulling out when they are low. We focus on short-term performance and forego long-term gains. Above all, we do not practice efficient asset allocation and portfolio rebalancing. Efficient asset allocation requires staying away from behavioural biases of greed and fear. And, WhatsApp forwards.

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