Investors shouldn't get lured into investing in a trending asset class if it doesn't suit their risk profile
It is a fallacy to chase rising asset classes and one that investors fall to more often than not. In the words of Warren Buffett, one should be a little greedy when others are fearful and a little fearful when others are greedy. However, it’s not uncommon to see investors’ brains wired to invest money in an asset class that has done well in the recent past. This behaviour, termed as ‘Recency Bias’ is the human tendency to assume that recent trends will continue. Investors chasing short-term returns fall into the trap of investing in winning asset classes.
Historically heavily chased asset classes eventually revert downwards, shortly after a majority of people jump aboard. Investors should understand that various asset classes go through cycles and if an asset class has delivered supernormal returns in the recent past, it is unlikely that the same trend will continue well in the future.
Understanding the fundamental drivers of the performance of various asset classes is the key to investing at the start of an upcycle to maximize returns. For example, the ideal time to invest in gold was in 2018 at the very beginning of the uptrend. At that point, the future returns were not visible but what was visible were the following factors that affect gold prices, constant sustained demand from global Central Banks and investors, geo-political uncertainties due to the US-China trade war and Brexit coupled with the relatively lackluster performance of equity and debt were conducive for increased demand and price for this safe-haven asset.
However, the returns earned by investors vary depending on the time they chose to invest in the yellow metal. Chasing the safe-haven asset when it had already significantly risen, resulted in below-par returns. If an investor had invested in gold at the start of the upcycle in October 2018, he would have earned handsome returns of 59.15 per cent on an absolute basis by the end of 2020. If the same investor had invested in April 2020 at the first peek of the yellow metal as there was a surge in global and domestic demand, he would have generated absolute returns of just 15.64 per cent by 31st December 2020. For those investors who jumped the wagon when the yellow metal touched Rs 50,000 for the first time on 29th June 2020, their investment would generate only 3.31 per cent by the year-end.
Currently, we are seeing the same trend for International funds. The last 2 years' returns have been fabulous and looking at that the Indian investor who had historically always preferred to invest in the domestic market now wants to invest in international funds. But most are not realising that if the long term average is 10-15 per cent and the last 2-year returns have been 20-50 per cent then the coming years mostly would see mean reversion. Also, from a fundamental perspective, such high returns are not sustainable over a much longer time. Hence, we have the view that diversification to Indian equity is a good addition to the portfolio but the clients should enter with limited allocation and muted expectations.
This performance chasing can be hazardous to an investor’s wealth. This may cause investors to buy high and sell low as they direct their corpus or cash flows to the trending asset classes. This might interfere with financial planning and retirement planning throwing the investor in financial jeopardy. While it is a natural tendency to chase past performance, it gets unavoidable as financial media tend to encourage this behaviour by highlighting investments that have done well recently. In the case of most financial instruments, the disclaimer of ‘past performance does not indicate future performance’ is very significant. Hence investors should take into account their risk profile, short term, and long-term financial goals before chasing trending asset classes or other financial instruments.
The only solution to this is prudent asset allocation. As 11 players in a cricket team play their positions well to ensure the team wins, investors must treat their assets similarly. The portfolio should be constructed to ensure that each asset class plays its respective position to ensure financial stability and wealth creation through various market cycles. Investors must not get lured into investing in a trending asset class if it does not suit their risk profile or long-term goals.
The author is Head at Anand Rathi Preferred
DISCLAIMER: Views expressed are the author's own. Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.