Edge of Knowledge

We often overhear conversations on the following lines:

• I have decided to invest in ABC Mutual Fund
• Why? Are their investment and risk management processes better than others?
• No, it's headed by a rockstar fund manager who has recently been awarded as fund manager of the year.
• Are you sure they will be successful next year too? What if they quit ABC and join some other fund house?

And it's easy to see why people go after names/ reputations/track records.

Returns on mutual fund investments are unpredictable. There are lots of uncertainties in the way markets behave. One, therefore, tends to take comfort in past performance/ image. But investors often forget that what worked in the last decade, last year or even last week may not continue to work in the future.
Strong processes, therefore, are critical when you choose your investment managers.
Fund managers do not have a magic wand. It is often said that fund management is a combination of science and art - both processes and people play an essential role. But processes are paramount, and people need to work within the boundaries set by processes, and their actions must bound the processes. This is to avoid human biases and errors that may otherwise creep in.
This is not to say that fund managers are unnecessary, and processes alone can run the fund. It is the systems and processes that help the manager make optimal decisions.
The priority of the fund manager is to generate alpha, that is, returns that are higher than the benchmark. This is done by allocating funds and portfolio construction within the broader framework set by the fund house.
Don't go by what your investment advisor or relationship manager says about the star fund manager. They may be highlighting the manager's performance during a bull run. However, the real test of a manager is their performance during various market cycles.

Mutual funds driven by strong processes with a robust risk management framework are less likely to witness extreme variations in returns.

It's a familiar story during every bull run...

The stock price of the company keeps scaling new highs every few days. It lures you to jump on the bandwagon. And within a few days, you exit with healthy returns.

You repeat the same with another well-performing stock and are rewarded handsomely again.

The experience lures you to try this with another stock with all the gains you have made so far. But by this time, the prices start to correct. You persist for some time, waiting for the cycle to reverse and press the panic button.

It is more common to the stock trading than stories of people who exit with handsome profits. Therefore, experts advise that one should not try to time the market and/or run after abnormal returns. Because you rarely know when the next downturn would begin, let alone predict a Lehman or COVID-19 pandemic-type collapse of the stock or bond market. The market goes through ups and down; cycles are the only thing predictable about the financial markets.

If you are investing consistently over time with an objective in mind, then your investment might be shielded from the stock market cycles.

What pays, in the end, is investing at regular intervals, as the returns will get averaged out.

How will you know if returns are consistent returns?

Returns should not be seen in isolation. One way to see if returns are consistent is to compare with the benchmark over time. The fund's net asset value can go up or down, but as long as it is more than the benchmark over the long term, the returns are seen as consistent.

Equally important is checking the consistency of a mutual fund in delivering returns before investing. A fund may have delivered consistent returns for one or two years but not have performed well over a five or ten-year period.

Choosing a mutual fund is the first step in ensuring consistent returns to get you closer to the desired goal.

However, there is a caveat: merely investing in mutual funds does not guarantee consistent returns, as returns are a function of market conditions. There could be volatility in the short run, but investing over a longer timeframe could help beat volatility and help increase your returns.

Professional experts manage your money in mutual funds with real-time and crucial market information. It is the most significant advantage of investing in mutual funds.

A mutual fund with strong processes and risk management is more likely to deliver consistent returns. Trust an investment manager who will invest in the highest-rated companies to minimize credit risks and the schemes which are in sync with the investor's risk appetite.

Funds investing in various asset classes with low correlation can help deliver relatively consistent returns - by making investments in debt and equity in a predetermined ratio. If the balance gets altered due to market fluctuations, assets are reallocated to get back to the predetermined level. Some funds have an inherent asset allocation mechanism, like balanced advantage funds.

So, pick a mutual fund with strong processes and risk management.

Many of you would laugh at the question. The goal behind any kind of investment is to make the money grow. Isn't that simple?

No worries; let's stick to this line of reasoning.

Next question: how much growth are you looking at?

"As much as possible," would be your answer. "I want to always put my money in an asset class where it grows the maximum"

No problem. How will you make sure that you are always invested in an asset class/ fund that is doing the best?

"I'll keep tracking the returns of all funds and keep shifting to the ones doing well."

Have you started to realize the problem with this reasoning?

Investments Experts call this "trying to time the market" and they have been saying, for decades now, that no one can time the market.
But the quest continues in all earnestness. No wonder, then, that many mutual fund investors end up withdrawing their investments prematurely and often do not make the money they aimed to make.

Obviously, something is wrong fundamentally. Turns out, the thing that is wrong here is the belief that your investment always has to be in an asset class that is performing the best. The experts will tell you that this is an unrealistic, and more importantly, an untenable expectation.

What actually builds long-term wealth is 'compounding over a number of years.'

Let's understand compounding first.
Compounding is a mathematical process that can multiply your potential earnings from an investment. The compounding process ensures that you earn interest on your original invested amount and also earn interest on the returns.
Compound interest may make your money grow faster because interest is calculated on the accumulated interest over time as well as on your original principal. Compounding can create a snowball effect, as the original investments plus the income earned from those investments grow together.

This magic is called 'Power of compounding'.
The first lesson of today, therefore, is that one needs to invest for a longer period of time if one wants to build wealth.

However, the trouble is, most investors don't keep investing for this long. They often get influenced by market fluctuations or spending temptations and end up not giving their mutual fund investments enough time.

This is where a 'Goal' comes in.
If you attach a long-term goal to your investment, you would invest till the time the amount is actually needed. For example, if your goal is to create a corpus for your daughter's higher education, and if she is 2 years old today, the chances of you investing, for say 20 years (till she is 18 and needs that amount), are higher.

Astute investors, therefore, always link their investment to a goal and keep investing diligently until it is time for the goal to be achieved. This helps them stay focused on the goal and not be impacted by the market volatility or other similar distractions.

So, what is the goal you are investing for?