03 Apr Why Investors will never make money from Equity Mutual Funds?
First time investors get very attracted to huge returns and based on the statistics presented to them, they start investing without a proper plan. They start as SIP for a small amount like Rs.1000 and invariably get disillusioned after few months. After a few months they feel that that their small amount of monthly SIP has not made them a millionaire and worse, it has made them poor. They start to doubt if they should continue with the Investment Plan or move over to some other investment, which promises even higher return.
It is a simple fact that, one needs to stay invested for atleast 5 years to make any reasonable returns from Equity Investments.
What the above Statistics Say?
- 4% of Equity Investors stay invested for less than a month
- 7.2% of Equity Investors stay invested for only 1-3 months
- 14.5% of Equity Investors stay invested for only 3-6 months
- 23.9% of Equity Investors stay invested for only 6mts -1year
- 22.1% of Equity investors stay invested for only 1-2 years
In all, 71.4% of Equity investors stay invested for less than 2 years! It is most likely that these investors would not have made reasonable returns, since their investments were held for less than 2 years. Remember; it requires a minimum of 5 years of staying invested to make reasonable returns from Equity. It is also possible that, they may have stayed invested in Equity, but switched to other Equity Schemes. Either way, their returns might have been sub-optimal.
Among the remaining 28.6% investors, data is not available for the quantum of investors who stayed invested for 5 years or more. Over the last 4 years of studying this data, it is found that the percentage of investors holding on to equity investments for more than 2 years is gradually reducing and this is certainly not good for the investors.
If 70% of the Investors are not making returns on the investments, the overall disillusionment towards equity as an investment vehicle will increase leading to more and more investors staying away from the capital markets.
Much worse, there is a minuscule percentage of Investors stay really for a long period of time and still don’t make enough returns. They are the diligent followers of Goal Based Investing and end up waiting for the Goal (Retirement or Children’s Marriage) to happen before redeeming their investments. Imagine the loss that can happen to this investor, if the market falls 50% in the year of retirement, despite having stayed invested for long period (sometimes even 20 years)
What can be done to help these investors to make reasonable returns?
While investment approach is very simple, it is the investors’ behavior that’s complex. To overcome complex behaviors, we need simple rules which can be part of System 1 thinking of our brain as Nobel Prize winner Daniel Kahneman explains in his book – “Thinking Fast and Slow”
Apart from creating simple rules, importantly we need to create a habit of looking at Risks in investment and not Returns from them.
If we want high returns, we have to take high risk. There are no options in this world which can give high returns at low risk. But taking high risk does not guarantee high return. This confuses us all the time. So, should one take Risk or Not? Furthermore, it has been proven that Human beings cannot take right decisions when it comes to risk taking. There are number of researches in behavioral economics which has proven that we either take less or more risk and most of the time it is wrong, we take risk when we are not supposed to, we avoid risk when we are supposed to embrace it. In our workshops common answer by most participants is – They will use equity for their Emergency needs and FD for retirement planning.
But, given the unpredictable and increasingly volatile situation we face today, how much risk should one take. The many thumb rules like % of Equity in Investments = 100 – Age etc have not worked. Take for instance, a youngster working in a Multinational who suffers from zero bank balance for most of the month; would no way be able to take risk as compared to a retired professional who has, say 1 Crore in his bank. The other approach is to have a Goal Based risk approach. The big limitations in this include “shifting goals” and also inability to map the goal with the Market Cycle. For instance, an investor assuming to achieve a goal by 2028 and hence gets into Equity, may run the risk of a market fall in 2028 and hence being unable to achieve his / her goal. Also, managing multiple goals – which most individuals have – is a complex problem.
Keeping all these in mind, we have come up with a simple approach to asset allocation and risk management which takes care of implementation challenges and complex Behaviors.
Here is a simple rule we present – which we call 3 – Bucket Approach to Investments.
Investor should imagine 3 buckets for Investment. The first bucket is short term needs (typically cash needs for immediate year), Mid Term Bucket – which consists of cash needs for next 5 years. Investors should fill these two buckets on priority. Bucket 1 which is short term bucket should have at least 6 months of monthly salary or 1 year of expenses if Investor is not working and don’t have regular salary. Priority is to fill this bucket at the earliest and keep maintaining minimum balance as mentioned above all the time. Liquid Mutual funds are the ideal option for this bucket. If this bucket is not full, investors will be forced to withdraw money from Long term bucket and end up facing a loss.
In the second bucket, investor could have amount which will be required for all their planned Big Expenses expected in next 5 years, for a retired investor one could have next 5 year expenses in this bucket.
Before, starting to invest in High Risk investment options like, Real Estate, Equity Mutual Funds, etc, Investor should fill these 2 buckets on priority and learn to maintain minimum balance. Once they are able to confidently manage these 2 buckets, they can then start thinking of long-term bucket.
Long term bucket has only two purpose – Retirement and children’s marriage. It is very difficult to plan when they will happen. So, investors should not fix them selves to time frames, but they should have rule to make returns on this bucket. Bucket 1 & 2 at best will help investors to tide over the inflation, but bucket 3 can help grow wealth faster. Rather than keeping a time frame for investments, Investors should have rule like – 5 years and 15% return. If both conditions are fulfilled, then gains must be realized and 3 buckets must be rebalanced. Bucket 3 must be filled, slowly and steadily, if there is a large sum available, in it is better to keep them in Bucket 1 and use a process called Systematic Transfer Plans offered by mutual fund companies.
Investment should be redeemed from 3rd bucket only during market growth cycles in a planned manner and it should not be withdrawn to meet expenses. Any cash needs must be withdrawn from bucket 1 or 2. The bucket three should be filled through SIP or STP route. By doing SIP or STP investor can average cost of purchase and can hope to get better returns. Bulk Investment in third bucket can not only lead to losses in short term, but also may take long time to recover.