Thursday, April 15, 2010

Why Investors must look beyond returns??

Ask an investor, which investment avenue he wants to invest in and there’s more than a fair chance that he will say – the best performing one i.e. one that can deliver the highest returns. Sounds reasonable, doesn't it? Why would an investor like to settle for anything less than the best, right? The trouble with such an approach is that it oversimplifies the investment process. As a result, emphasis is laid only on the returns aspect; vital factors like risk and suitability are ignored.

Far too often, investors and advisers alike are guilty of falling prey to the allure of high returns. The rationale being, investing is all about clocking the highest return, hence any avenue that can deliver on this front gets the thumbs up. Don’t get us wrong. We are not suggesting that returns aren't important or that there is necessarily something wrong with an avenue simply because it can deliver a better showing on the returns front vis-à-vis other avenues. However, selecting an investment avenue based solely on its performance is certainly a flawed approach.

In the first place, such an approach erroneously assumes that the investment avenue (say a mutual fund for instance) is an end, rather than a means to achieve an end. While investing, the end should be a tangible goal like providing for one’s retirement, buying a car or simply wealth accumulation, expressed in monetary terms. And once the target sum has been established, appropriate avenues to achieve that end should be chosen. Conversely, if the investment process begins with the selection of the investment avenue, the investor ends up investing in an aimless manner and may never achieve his goals.

Second, by investing in an avenue based solely on returns, the investor runs the risk of getting invested in an avenue that might be unsuitable for him in terms of the risk involved. For instance in the equity funds segment, by and large one would expect a diversified equity fund (which invests its entire corpus in equities) to outperform a balanced fund (which invests around 65%-75% of its corpus in equities and the balance in debt instruments) in times when equity markets are rising. But from an investor’s perspective, the key lies in determining what’s right for him.

For example, assume that a balanced fund can deliver a 12% CAGR over a 5-Yr period; conversely, a diversified equity fund is equipped to deliver a 15% CAGR over the same time-frame. Say an investor wishes to accumulate Rs 500,000 for a holiday 5 years down the line. Now the investor has to choose between investing in a balanced fund or in a diversified equity fund. Should the investor decide to build a corpus using a balanced fund, he will have to invest around Rs 6,223 per month or Rs 78,705 pa. Conversely, opting for an equity fund will necessitate a lower investment i.e. Rs 5,792 per month or Rs 74,158 pa.

Most investors might instinctively opt for the equity fund option on account of the higher return (i.e. a lower investment amount). However, while making the choice, the risk factor has been ignored. On account of the debt holdings in the portfolio, the balanced fund is invested across asset classes i.e. equity and debt. Over the 5-Yr investment horizon, should equity markets witness a rough patch, the balanced fund will be better equipped to protect the investor’s corpus. In effect, the trade-off for the higher investment amount is the proposition of delivering during a downturn in markets. Before making a choice, the investor should first evaluate his risk appetite and then choose between the balanced fund and the equity fund.

Another reason investors opt for the best performing avenues is excitement. Yes, you read that right. There is a section of investors, which believes that the investment activity should be exciting; hence selecting investment avenues offering the highest returns is justified. For the record, investing has nothing to do with excitement; on the contrary, investing is serious business and is all about achieving one’s predetermined financial goals. Seeking excitement from the investment activity amounts to trivializing it.

In conclusion, investors would do well to look beyond just returns while making an investment decision. Sure, returns are important, but certainly not a parameter to be considered in isolation. The key lies in looking at the investment activity in totality and then making a decision. If not, investors run the risk of missing the wood for the trees.