An investor’s returns are weighted based on his cash inflows and outflows
By Priya Sunder
A well-known folk tale tells the story of six blind men meeting an elephant for the first time. The first man touches the pachyderm’s large, wide body and said the animal must be like a wall. The second feels the long trunk and remarked the elephant must look like a snake. The third felt the thick legs and guessed the elephant must resemble a tree and so on… Each blind man imagined his version of the elephant and none of them were right. This story rings true even when we observe investors’ behavior towards their portfolios. Like the blind men’s limited perspective of the elephant, each investor’s understanding is random, incomplete and unique, but very often far from reality.
Investor A’s experience can be unlike Investor B’s because Investor A could have bought when the markets were low whereas Investor B would have waited on the sidelines during market slumps and invested when it rose. Investor A could have invested steadily via SIPs or STPs, thereby averaging out his returns better than Investor B, who chose to time the market and invest lump sums. Investor A may have stopped himself from moving in and out of schemes frequently, whereas Investor B may have chased the best performing fund and churned his portfolio often. The timing of the investment and the time spent in the investment can be different for each investor.
Then there are differences between the returns of a scheme and an investor’s returns. Often the investor’s returns are low even though the fund has had a stellar performance in the past and continues to be a high-ranking fund today. A scheme may show a 16% CAGR over 10 years in the fact sheet, but in your portfolio, the scheme shows only a 6% return. How does one explain this?
A fund’s total returns may measure its performance across a 5- or 10-year period, or perhaps since inception. However, an investor’s tenure may not match the fund’s tenure. Even if it did, investor behavior may be different from a fund’s behavior. An investor may have entered the scheme five years ago through an upfront investment, continued a SIP for two years, redeemed after four years and invested a further lump sum in the fifth year. For an investor who has a SIP running in a fund, the tenure of his first installment may have delivered long-term returns that matched that of the fund, but his most recent installment may have had zero or even negative returns, depending on the prevalent market conditions. An investor’s returns are weighted based on his cash inflows and outflows, which in turn are skewed by his behavioral biases which influences when he enters the scheme, how long he stays invested, when he chooses to exit and so on.
The internal rate of return (IRR) is a tool used to measure an investor’s return on his investment. It includes the value of all the inflows and the outflows at different periods of time. The investment’s return is a different calculation. The data that you see on a scheme’s fact sheet or prospectus is based on the scheme’s total return, which includes growth in the portfolio as well as income generated by the investments in the portfolio over a period. When the IRR is less than the total return, it could indicate that the investor may have entered when the returns were high and exited when the returns were low.
When an investor’s time horizon converges with the that of the scheme, the gap between investment and investor returns shrinks. The gap tends to be starker in the case of schemes which have higher volatility or during times when the markets are choppy. This is primarily because investors may not be able to stomach the ups and downs of the markets or the scheme’s performance. Such volatility makes them nervous and they may exit when the returns are low and re-enter when the markets look more promising. This is so true of investors who exited during the lows of 2008 and re-entered when the market was on the upswing. This is precisely the sentiment that investors should avoid in today’s turbulent markets.
Studies have shown a nearly 6-7% difference between investor and investment returns. It’s important to learn a few lessons here. One, if the scheme is of high quality, then have conviction and stay invested. Two, don’t let behavioral foibles come in the way of disciplined investing. Three, stay the course with your goals and target asset allocation. Exit when this balance is off or if you need money. Everything else is irrelephant. Sorry, irrelevant.