Human beings' innate liking of the new and the innovative, and our love of interesting stories, is a major factor in the mess that many of us make of our investments. A good proportion of us appear to be unable to choose an investment unless it appears to offer an interesting story.
Consider the following. Two mutual fund salesmen approach you with a pitch to get you to invest in two different funds. Salesman A has a new fund that, according to the fund company, is designed to exploit the coming shift of economic power from the hitherto developed countries to the emerging economies. In this fund, the investment managers are supposed to specifically choose those companies which are in businesses which will benefit from this shift. The sales literature goes on at length about this coming shift and paints a convincing story of why this shift is inevitable and how some businesses will be able to take advantage of it and some not. Salesman B, on the other hand, tells you about a fund that has a reasonably good track record and invests in a combination of sector and types of company that will be well diversified at all times. That's all there is to fund B.
It doesn't take much insight to see which of these is going to attract more attention and capture more mindshare than the other. It is also fairly obvious that this is exactly the same instinct that drives people's choices in almost any kind of purchase decision from clothes to cars to computers. Unfortunately, the downside of investing like this is far worse than buying a car with a few more features than you will really need. The downside is severe because people who invest on the basis of features don't do it once in a while-they do it all the time.
I see portfolios that are composed of 10, 20 or even more funds, everyone of them some sort of a sector or speciality or thematic fund. Basically, our instinct makes us inherently interested in the stories that these funds are based on. It takes a special effort, an over-riding of that instinct with logic, to invest in simple funds that are more suitable for our investing needs. Simpler, general purpose funds with a good track record are suitable because they are a superset of all those storytelling funds whose stories make sense. Think about this point carefully because this is the crux of the matter. There could be times when energy or infrastructure or technology stocks make somewhat more sense than others. However, that doesn't mean that you, the investor, has to identify those times and then identify the right energy or infrastructure or technology fund to invest in. All it means is that if most (or all) of your funds are invested in a general-purpose fund with a good track-record, then the fund manager will appropriately emphasise energy or infrastructure or technology stocks when it's the right time to do so. However, unlike a specialised fund, he won't go overboard with that theme and will stay within an overall framework of diversification. Once you are able to recognise the illogical actions provoked by our liking for interesting stories, you will see that it doesn't make sense to invest any money at all in anything but fully diversified funds.
And there's no shortage of such funds. If you look at the returns history and the ratings on a mutual fund website like Value Research Online, you'll easily be able to identify such funds which have long histories of good performance. They often don't fit into someone's marketing pitch so no one may be selling them actively, but that doesn't mean that you can't make your own choices.
This article was originally published on June 02, 2010.
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