Relying On Past Performance Alone Can Backfire

Hemant Rustagi
Chief Executive Officer, Wiseinvest Advisors

Many investors tend to rely heavily on past performance while selecting funds to invest in. They believe that top-performing funds cannot go wrong and, in all likelihood, would replicate their past performance in future too. Although past performance has to be an important consideration in the selection process, it is critical to look for funds that provide the right balance between one’s risk taking capacity and the fund’s ability to provide commensurate rewards.

In other words, the key is to build a portfolio consisting of funds that allow you to have the right level of exposure to different segments of the market such as large-cap, mid-cap and small-cap stocks. In fact, your portfolio must always have a bias towards large-cap stocks. However, if you rely on past performance alone for selection of funds, the chances are that you may either end up investing in very aggressive funds or conservative funds depending on the performance of the stock market.

Remember, basing your investment strategy on past performance (especially recent performance) can backfire. However, once the portfolio is built, it is important to measure and analyze the performance of funds on an ongoing basis to ensure that your investments remain on track to achieve your varied investment goals. Total return is the best way to measure the performance of funds in the portfolio.

Total return is the sum of two components— dividend and capital appreciation. When combined, these elements provide the “big picture” of what your investments have been doing over time. In other words, total return is a useful tool for making comparison between the performances of funds in the same category or a fund and its benchmark. Securities and Exchange Board of India (SEBI) has mandated that all mutual funds must benchmark the performance of their schemes to total return indices instead of the simple price return indices.

While assessing total return of your investments, there are some important issues that need to be taken into account. Total return can be presented either on a cumulative basis or as an average annual compounded rate. However, it is not advisable to rely solely on cumulative return as it does not reflect the true picture. For example, a fund with 10 years cumulative return of 100 per cent did not earn an average compound return of 10 per cent; the annual compound return in this case was 7.20 per cent.

Another aspect to understand is the difference between compounded rate of return and simple rate of return. For example, a fund with an annual return of 20 per cent, 25 per cent and a negative return of 15 per cent on three consecutive years will make Rs. 100 grow to Rs. 128. This works out to an average annual compound rate of 8.30 per cent. On the other hand, if the returns are added to arrive at the simple rate of return, the value would be Rs. 130. In other words, the simple rate of return would be 10 per cent.

Let us now understand as to why the average compounded return should be taken into account to get a clear picture. For example, while the average return on an investment that provides a positive return of 100 per cent and negative return of 50 per cent in two consecutive years would be 25 per cent, the average compounded rate would be zero. In this case the initial investment of Rs. 100 would double to Rs. 200, only to decrease to Rs. 100.

As is evident, it is important to measure the performance of your mutual fund investments in a manner that it reflects a true picture. Understanding how performance fits in with your overall investment strategy can help you avoid making ad hoc and abrupt decisions.