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Previous year returns are the worst guide

If you invest based on what happened last year, you’re in for a surprise at the end of the following year; returns may be similar or may be nothing like what you expected.

If you are relying on the last one-year return to guide you in choosing a mutual fund to invest in, you’ll probably end up picking either a long-term debt fund, a government securities fund (debt) or a top performing dynamic bond fund. These are the funds which have delivered the highest returns in the last one year ranging between 14%-21%.

Who doesn’t want to get a slice of that pie? But let’s think about this again, and this time rationally. Mutual funds are market linked products, which means return can vary from year to year, month to month. This also means that the last one year’s return is not a mirror for what can be expected in the next one year. If you invest based on what happened last year, you’re in for a surprise at the end of the following year; returns may be similar or may be nothing like what you expected.

Sample this: dynamic bond funds which are posting one year returns in the range of 14%-15% today, delivered 0%-1% return for the period between August 2017 to August 2018.  Had you been making this choice (solely based on past returns) a year ago, would you have picked a dynamic bond fund? Probably not. However, to get the benefit of the 14%-15% previous year return, you would have had to invest a year ago.

Can’t predict market trends? What should you do?

Your investments need to reflect your future financial needs. In other words, you should invest in financial securities that help you achieve your financial objectives be it retirement, down payments, wealth creation or marriage fund. Once, you understand the purpose of the investment, you will be able to make a better choice of the financial security that will help you achieve the expected return. Simply, picking a security that has delivered a good one-year return will create unreasonable return expectations and lead you down an unknown path. 

Performance track record is not the same as previous year performance. Rather, it entails measuring performance in various market cycles, looking at 3- 5-year average performance, consistency of returns and the risk adjusted returns.

Got down your objectives, now what?

Once you have identified the reason for your investment, choosing funds involves several factors. The asset class it invests in, the quality of the individual securities it holds, the fund manager’s experience, the investment strategy and performance track record, among other things.

Performance track record is not the same as previous year performance. Rather, it entails measuring performance in various market cycles, looking at 3- 5-year average performance, consistency of returns and the risk adjusted returns. The next step is matching these financial performance metrics to the fund strategy and asset class. These measures of fund selection are not exhaustive, there are many other nuances that get added. It is not an easy task to pick the appropriate fund and match it with a reasonably accurate return expectation. 

Focus instead on a list of ‘don’ts’

If the above to do list sounds daunting, focus on what you shouldn’t do. Don’t invest based on last one-year return. Don’t try to analyse mutual fund returns without understanding the fund’s investment strategy. Don’t forget to measure risk in context to the return. Don’t try to do all this yourself, get an advisor if you need to. 

It is said that not doing something is just as important as doing something. When it comes to making investment choices, this statement holds true especially in current times where uncertainty rules across asset classes. 


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