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The Truth Behind Fund Recovery

With markets recovering somewhat, salesmen are back to selling dubious stories to gullible investors

It is often said that public memory is short. And guess what, it really is short. In fact, it's very short. In my observation, the brief recovery that has taken place in the investment markets is now well on its way to proving this. As soon as stocks and mutual funds have had a few good weeks, the same sharp salesmen have crawled out of the woodwork and started selling the same dubious stories to the same gullible investors. As the French say, plus ca change, plus c'est la meme chose.

One of the drivers of this behaviour is quite simply, a poor understanding of the arithmetic of percentages. I'm serious. If more investors had a basic grip on the calculation of percentages, they would be less likely to chase short-term performance. Here's a telling example. Consider fund 'X', which was one of the worst-performing funds from the markets' January 2008 peak to their March 2009 bottom.

During this period, this fund was down about 81 per cent. Then came the markets' recovery. From the low-point in March to last week's peak, this fund gained 48 per cent. This was almost the best performance of any mutual fund during this period. There's nothing remarkable about this worst-to-best transition. This fund. and others like it, is heavily invested in speculative mid-cap stocks. When such stocks started moving, these funds started doing well.

Considered in isolation, a 48 per cent gain sounds phenomenal. It even sounds as if the fund should be well on its way to wiping out the blot of the 81 per cent decline. However, the arithmetic implication of an 81 per cent drop followed by a 48 per cent rise is rather severe. The fund made your Rs 100 into Rs 19 (81 per cent down) and then increased the Rs 19 to Rs 28 (48 per cent up). Overall, it has taken your Rs 100 to Rs 28, which is a 72 per cent drop. Not so good. To get back to Rs 100, this fund will have to gain 360 per cent more. And that's going to take some doing, recovery or no recovery.

Tragically, the implication of this simple arithmetic is not appreciated by many investors. What this means is that for any non-professional investor who is putting his or her savings in mutual funds, the only sound strategy is to chase stability and not recent returns. In general, funds that have done the best during the recent good times dropped the most during the crash. More than half of the funds that are in the top quartile in recent times were in the bottom quartile during the crash. Mutual fund investors who chase recent performance generally get nothing but funds that do very well when the going is good, but wipe out huge chunks of wealth when the markets crash. The losses are so severe that it is impossible to recover from them in any reasonable time frame. It's easy to sell and buy based on the latest performance alone.

Unfortunately, this sort of investing is creating a Darwinian bias against conservatism in investment management. Short term performance sells when the markets are rising. And when they are falling, then nothing sells anyway. All investors need to do is a little bit of basic arithmetic to avoid falling into this trap.