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A learning experience

Aggregate money flows in and out of mutual funds don't actually mean what they appear to

A learning experience

A few days ago, you might have seen a news report that investors' money flowed into mutual funds in March, when the equity markets were dropping sharply. In contrast, during November, when the equity markets were at an unprecedented high, money flowed out. The general idea that the news stories seemed to suggest was that of market-timing investors who were smart enough to buy when the markets had crashed and then even smarter in November when they sold.

Sounds like a nice story. Unfortunately, it's not true. There is an assumption here (stated in some places, unstated in others) that the two parts of the story refer to the same set of investors, that is, the ones who bought in March were the same as the ones who sold in November. A lot of people who comment on this just talk about 'mutual fund investors' doing this or that as if they are one single entity.

This makes for a nice story but there is no basis at all for making such an assumption. I'm in touch with a lot of investors as well as investment professionals who serve a large number of investors. Almost universally, the investors who sold in November were not the ones who were enthusiastic back in March.

In reality, the November phenomena consists almost entirely of people who are waiting to break even before quitting. This is something that almost all new investors and many older investors also tend to do. They invest in something, it drops in price/NAV and their returns move into negative territory. Now they feel that if they quit at that point, they would have 'booked a loss' and that is, in a manner of speaking, admitting defeat. So, they feel that they must persist and wait it out till that particular investment breaks even, goes into even territory and then they can sell and 'book a profit'. This is a common mentality and is even enshrined in official investment policies of many organisations.

At any point, there are a large number of mutual fund investors who have not gone through a cycle of seeing weak markets and sagging NAVs and then a recovery. When the markets crashed, they were in a state of panic, especially because all indications were that this could be a long story. In a way, they were all lucky that the low phase passed quickly, at least for the time being. Come November and December and most equity funds are above where they had started the year. That's great of course. In fact, that's actually very good for smart investors who continued with their SIPs and are investing for years. The downturn in the markets just meant that they were able to 'buy low' for those months. Remember, low markets help you when you are investing.

However, what about the newbies who bailed out? That's unfortunate and results from a misunderstanding of how profits and losses in investments should be calculated and thought about. What matters is your entire investment portfolio. An individual investment does not matter; it does not make sense to measure profitability that way. This makes sense only if, for some reason, it's important for you to count the profitability of each stock separately. If you are thinking of your investments as a portfolio whose gains matter as a whole, then it doesn't make much sense.

Obviously, it does matter how good or bad an individual investment is. If it's a bad investment or is unsuitable for you for some reason, then why wait? Get rid of it immediately. No point waiting for this book-a-profit point. Better deploy the money in a good investment - the sooner the better. This is a critical part of investor education, and somehow it comes only to some investors and then only with hard experience.