Are you still doing Rearview mirror Investing?

Rearview mirror investing

You must have heard the ubiquitous disclosures by the MFs, “Past performance is not a guarantee of future results”. This standard footnote warns that extrapolating past trends could lead to a sizeable gap between expected and realized returns. However, we rarely follow this advice in practice. Often we have seen investors buying MF or any other asset class for that matter, habitually looking at past year performance.

It is perilous to look backward while picking any asset class including MF. It is akin to steering a car by looking through the rearview mirror, which could be OK if the road remains straight, but a catastrophe when the car comes to a curve. Investors’ historical performance seems to demonstrate that the footnote’s warnings should really be taken to heart.

How to deal with Investment Noise?

These days you can find tons of information on investment, be it newspapers, internet, financial magazines or entities assigning star ratings to different MF schemes. Now the question arises – how should you react to these noises? I will try to give the answer through an example.

Suppose, you are traveling in a car and you hear a lot of traffic noise. What will you do? I am sure you will roll-up the window glass and start enjoying your own favorite music. Similarly, you need to cut the noise that interferes with your portfolios. One of the keys to investment success is to avoid the noise and become a less distracted, more purposeful investor.

Does it pay if you invest in the previous year's Performing Mutual Funds?

Many a times investors buy MF looking at the 5-star ratings which are easily available on the internet. However, the star-rating system is largely based on the historical return and volatility data and incorporates no information regarding the potential for a strategy to outperform in the future.

The Wall Street Journal, in one of the findings, had highlighted several points regarding the rear-view mirror approach of the star-rating system in predicting future performance:
a) Five-star funds’ average rating over the subsequent 3 years was only 3-stars.
b) Half of the funds that received a 5-star rating held on to it for just 3 months before performance waned.
c) For all the time periods measured (i.e. 3, 5, and 10 years), a 5-star US equity fund was more likely to become a 1-star fund than it was to maintain its 5-star rating

Anecdotal evidence suggests a similar story for us

We have tried digging deeper to find out how differently the Indian market has fared. We have looked at the previous ~10 years MF data (Jan 01, 2010 to Oct 25, 2019) to visualize how an investor would have performed if she had chased the past year’s performance.

Source: DreamLadder Capital Research; *  indicates return as on 25th Oct 2019, for funds selected during 2017; Each year ranking is based on returns as on 1st January.

This analysis is based on the assumption that investment in each MF Scheme is done on 1st January of every year while the selection of the top-3 funds is based on previous one-year performance.

The above table shows that if someone had invested looking at the previous one-year performance in any of the top-3 MF schemes of the Large Cap category, 15 out of 18 cases would have seen a decline in the ranking over next 3 years, while only 1 out of 18 cases saw improvement in the ranking with 2 unchanged cases during the same period.

Nonetheless, the average decline of ranking is 9.4 i.e. if the ranking of your selected MF scheme was 1st as per previous year performance, in the next 3 years your same fund will have on average 10th or 11th position in the Large Cap mutual fund category. We find a similar trend for the next ‘1 year’ or ‘2 years’ performance when the average decline in the ranking is 11 and 9, respectively.

Don't get into the rear-vision trap

This rear-vision investing is often termed as “chasing past winners” or “performance chasing” and is fraught with hazards. You can also fall into a rear-vision trap of focussing excessively on investment returns from the past and hoping that past investment winners will repeat their success in the future as well.

However, this strategy would have a detrimental effect on your portfolio performance. We believe future returns are more likely to be driven by future fundamentals, and not past performance. Therefore we advise our clients not to fall into the rear-vision trap.

Warren Buffett is attributed as saying that investing is simple, but not easy. We at DreamLadder Capital believe that the difficult part of investing is trying to bridge the gap between what’s happened and what lies ahead. Our mission is to empower you through education. This mission is our passion and what drives us to go to work everyday.

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