Investors earn less than the investments they make. Confused about how that could be? Here's what happens.
22-Sep-2022 •Dhirendra Kumar
A few days back, there was this news that an Axis Mutual Fund study has found that investors earn lower returns than the funds they invest in. At first, this must be sounding illogical to anyone who understands the maths of any investing. However, a closer reading shows what is going on. The secret is not in the maths but in human behaviour.
According to the reports, the AMC studied mutual fund returns generated over 20 years ending March, 2022. Over this period, actively-managed equity funds generated returns of 19.1 per cent p.a., but investors in such funds earned only 13.8 per cent p.a. This is a huge difference, and I really do mean huge. Over 20 years, 19.1 per cent means that Rs 1 lakh would grow to Rs 33 lakh while 13.8 per cent means just Rs 13.3 lakh. That's a life-changing difference - like being rich vs being middle class. Similarly, hybrid funds returned 12.5 per cent, but investors earned around 7.4 per cent. Again, the difference is gigantic. For investing Rs 1 lakh, it's actually Rs 10.5 lakh vs Rs 4.2 lakh.
Based on my experience, this is typical. I've always had the impression that investors earn far less than the actual returns of the funds. Why does this happen? I'm sure everyone reading this can guess the answer very well.
We investors are our own worst enemies. On the one hand, we are obsessed with choosing the best mutual fund to invest in. On the other, we buy and sell funds at exactly the wrong time, in a manner guaranteed to reduce our returns. The result - we choose good funds and then manage to earn returns that are not much better than those from a bank fixed deposit. The behaviour is quite predictable. Basically, it can be summed up as 'buy on excitement, sell on panic'. I think I should copyright that phrase. It has zero hits on Google, so I suppose I have coined it!
The meaning is self-evident. People invest only when there is great excitement in the equity markets. That is, when the prices are already sky-high. Then, they sell when there's great panic, when equity prices are crashing and mutual fund NAVs are sliding down. In toto, that amounts to 'buy high, sell low,' the exact opposite of what one should be doing. Instead of finding an optimal investing strategy, doing this brings investors to the reverse, a 'pessimal' investing strategy.
Do note that while I've been talking about mutual funds here, that's just because my discussion started with an analysis done by a mutual fund company. Everything that I say here is even more applicable to equity investors, the only difference is that a neatly packaged comparison like the above one cannot be done. In fact, what makes this happen in stocks are the twin mistakes of selling too early and selling too late. Of course, that's in different investments.
People buy a stock, and when they feel it has risen as much as it is going to, they sell it, thereby locking in the gains and booking profits. In reality, they are afraid that the profits will go away, or even just reduce. The regret and the embarrassment are not worth it. The feeling of success, of closing a trade at a high point, is too valuable to them. It's a victory. The evil twin of this behaviour is holding on to dud investments. In booking profits too early, investors are motivated by locking in a win. In holding on to a bad investment, they are motivated by not having to lock in a defeat. The net result is that investors tend to sell their winners and hold on to their losers.
At this point, I wish I could say that once investors understand this problem, they'll take steps not to make these mistakes. However, investing missteps whose root cause lies in human psychology are not easy to correct even when one understands them. Some will fix it, some will not be able to. That's the way the human mind works.
Suggested read: Fear and opportunity in stocks