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Move Past The Past

It is an unhealthy habit to read too much into past numbers & expect the future to emulate them…

Last month, Value Research’s magazine, Mutual Fund Insight, had published a detailed article on Systematic Investment Plans (SIPs). Among the illustrations that had been used in the article was one that analysed SIP returns over a very long period. This illustration showed the returns from a 15-year SIP. Part of the illustration was that the SIP amount was increased by 10 per cent every year. This was done to simulate how the investments of a real investor grow as his income grows.

In the same article, there was also an illustration of an SIP investment over the same period for the same amount every month. As it happened, there was a small difference between the returns in the two illustrations. In the case of a leading fund, the increasing investment grew at 30.85 per cent per annum while the other one grew at 30.20 per cent per annum. So far, so good. However, when readers’ responses to the article came in, I was surprised (shocked, actually) at the number of people who had read deep meaning into this tiny difference between the two returns.

The commonest reaction was that these illustrations proved that investing at an increasing rate was better than investing with a constant amount. This notion is of course wrong. In fact, it’s ridiculous. The examples prove nothing of the sort. In equity investing, getting this sort of a difference for what is essentially a hypothetical back-test over a long period is utterly irrelevant. It tells you very little about the past and utterly nothing about the future. That kind of a difference is just statistical noise.

In any case, SIPs are not a way to maximise returns in this manner. They are a way of keeping yourself in a disciplined and regular frame of mind and preventing yourself from reacting to the markets’ ups and downs. Any way of regularly investing in a good equity fund will work—an SIP just makes it a habit.

However, there are two broader problems here, one of over-reading and over-interpreting numerical analysis; and the other of appreciating the ways in which the past is a good guide to the future and the ways in which it isn’t. As investors, and as consumers of financial services which are actively sold, we are subjected to a lot of numbers that purport to help us tell good investments from bad ones. Many of us don’t have a good instinctive understanding of what is the scale of differences in numbers are relevant, even though we have such understanding in other areas.

For example, if a car salesman told you that one car was better than the other because it consumed fuel at 16.10 kmpl and the other at 16.14 kmpl, you’d laugh at him. But many of us wouldn’t be able to draw an equivalent conclusion about financial products. The other issue is that even if a difference is relevant about past numbers, does it have relevance for predicting the future. Suppose one approach to investing did yield a relevant difference in the past. Was the difference because of some inherent advantage, or was it only accidental? In other words, is it relevant to making decisions about the future?