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Do not base your plans on immediate past of the Investment as the financial environment constantly changes
Financial planning and investing is done to have a secured financial future, and it is done looking ahead. Unfortunately for a large number of investors, the first question while starting a financial plan is not what or which assets will perform better going ahead. Usually, the first question is which stocks, or products, performed better during the previous one year. So, while the investor is planning for the future, he/she is more intent on knowing what happened in the immediate past — a perfect example of trying to take financial decisions looking at the rear view mirror.
This is also true for investing in mutual funds. And that's one of the main reasons why you read the caveat on any mutual fund-related literature: Past performance may or may not be sustained in the future.
One of the overwhelming reasons for not investing looking at the historical performance is that the investing environment is always in a state of change, and the reasons for which a product performed well the previous year have almost certainly been replaced by a new set of factors, some of which are completely different to each other.
The investment environment is constantly changing with respect to government policies, interest rates, disposable income, inflation and also economic growth. And since all these factors have a bearing on the performance of mutual funds, stocks, bonds, gold, real estate, etc, so the sectors or stocks which had given strong returns earlier may fail to repeat such a stellar performance on a continuous basis. In fact, there is every chance that an investment strategy that gave you smart returns last year, may turn out to be a complete dud, and become the reason for your losses in your portfolio in the current year.
Besides that, investments follow a demand-supply pattern over the long term. They follow a cyclical pattern, going from a phase of low buying interest to a stage of being highly sought after and then again sliding to a phase of weak demand. These cycles come (among other reasons) due to changes in the domestic and international economic climate. Ideally, one should try to buy during the lower end of the cycle.
A similar approach is often observed among mutual fund investors. They look at the schemes that have given the most fantastic returns over the past one year, two years, three years or more and attempt to zero in on the best performer. True, such performances do reflect the consistency in performance of the fund manager (if the same fund manager has managed the fund through all these years). But rarely in the history of mutual funds has a fund manager consistently outperformed others.
So the question is how to get on top of this habit of investing by looking at the past performance. One of the more realistic decisions you can take is to try and understand just the basics of investing and then try to implement the same in your portfolio. Another way out is to depend on a good financial planner or advisor.
As expounded above, you could try and understand how government policies work, if there is any pattern in policy formulations by the centre and the states that can have some major bearings on your portfolio, the interest cycle, the economic environment, global factors, etc. It might seem like a complex task to begin with. But with the help of a professional financial advisor, the learning process becomes simpler.
Financial planners also suggest two additional ways of investing for the long term. One is to go for systematic investment plan (SIP), and the other one is to settle for passive index investing. You can go for one SIP in a mutual fund scheme or several SIPs in an equal number of fund schemes, depending upon your risk appetite and the time horizon of your investments.
Under an SIP, you invest a certain amount of money each month or quarter in a particular mutual fund scheme for several years. In essence, what an SIP does is it buys more when the markets are down while it buys less when the markets are up, thus bringing to the table a practice that financial markets call rupee-cost averaging.
The other option, that is passive investing, could be done by investing through exchange traded funds (
ETFs) which are based on a broad-based index. In these ETFs, the fund manager tries to replicate the index constituents in his/her portfolio. And as the index rises or falls, the ETF also rises and falls. The strategy to invest in index-based ETFs can also help you get a better return than a strategy based on rear view investment approach, because historically it has been seen that over the long term, that is more than 10 years, in a majority of the cases passive investing had given better returns than those who tried to time the market.
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