Don't chase past performers in equity markets, build all-weather portfolio

Performance chasing does not work in the equity markets. If you make investment choices based on recent performance, you may underperform an investor who chooses one strategy and sticks to it for the long term. A recent study by WhiteOak Capital Mutual Fund underlines this point.
 

Key findings
 

The WhiteOak study covered the period from FY06 to FY24. Over this period, the midcap (Nifty Midcap 150 TRI) and the smallcap index (Nifty Smallcap 250 TRI) outperformed the largecap index (Nifty 100 TRI). 
 

An investor who invested in the midcap index and stuck to it for the entire period would have earned an XIRR (extended internal rate of return) from SIP investments of 18.1 per cent. 
 

By contrast, one who kept switching his SIP to the previous year’s outperforming index would have ended up with an XIRR of 15.5 per cent. Similarly, an investor who stuck to the smallcap index for 19 years would have earned an XIRR of 16 per cent. 
 

One who kept switching would have made only 15.1 per cent.
 

The outcome was similar when the study was repeated using rolling return calculations. The bottom line: switching strategies does not boost returns.

Why switching does not work?
 

When investors switch from a fund that is not doing well to one that has performed well recently, they move from undervalued stocks to richly valued ones. 
 

“Purchasing more of richly valued stocks results in sub-optimal returns. An investor who stays with the underperforming index accumulates units at a lower average price, resulting in better returns when that index’s performance turns around,” says Chirag Patel, co-head — products, WhiteOak Capital Mutual Fund.
 

Money is made when you buy low and sell high. “Switching from an underperforming asset to a high-performing one means you do the opposite,” says Gautam Kalia, senior vice president and head–super investors, Sharekhan by BNP Paribas.
 

Markets are cyclical and mean reversion occurs across investment styles, market segments, and geographies over the medium to long term. 
 

“If you enter a fund based on its three or five-year performance, there is a high chance the fund’s good days are behind it and its phase of underperformance is likely to begin,” says Arun Kumar, head of research, FundsIndia.com.

Why do people switch?
 

A major reason is envy. “Investors must appreciate that in a market with hundreds of funds, some will always outperform the ones they own,” says Patel. Action bias and complexity bias also play a part. “People feel that taking more actions will help generate higher returns, but such causality does not exist. In investing, simplicity and inaction are often rewarded,” says Kalia.

What should you do?
 

Build a portfolio diversified across market caps, investment styles, and geographies. “Investors may divide their portfolios into five fund buckets: quality, value, growth at a reasonable price, mid- and small-cap, and international. Those who prefer a domestic portfolio may substitute international with momentum,” says Kumar.
 

Hold this diversified portfolio for at least seven years. While one or two buckets will underperform each year, returns are likely to be sound over a seven-year period. 
 

Such a diversified portfolio will also fall less during downturns.

Don’t stop SIPs during market dips

> Currently, 1-5-year SIP returns are high, lowering risk expectations; but typically, SIP investors go through three phases in first five years
 

> Disappointment phase: Returns drop to 7-10%, below expected 12-15%, causing disappointment
 

> Irritation phase: Returns fall to 2-7%, making investors consider fixed deposits; some give up

> Panic phase: Returns dip below 0%, causing many to abandon SIPs

> Market falls of above 10% are very common

> Market declines of 20-30% could bring down SIP returns to low single digits, especially

for newer (up to 5-year-old) SIPs
 

> Continue SIPs during downturns to benefit from purchasing units at lower prices