What does Sachin Tendulkar’s past performance tell you?

Well it tells you he is a great, talented, player with a fantastic attitude…that is all. You cannot use his past 2 years performance to predict what he will do for the next 20 years! Fairly obvious to the common man…but in mutual funds, he is willing to allow a 22 year old sales person convince him that a 29% return over 20 years will make him a millionaire..many times over!

Do not use past performance as a criteria please – whether it is cricket or mutual fund performance. Past is used to predict style, not how many runs he will score!

Past performance is not an indicator of future performance. Every mutual fund says something that in its literature. And yet, ignoring the past–in investing or in any other field–is rarely a wise move. What we should understand is that the past is only a proxy for the future. Peter Lynch says this very well when he says, “You cannot look in the rear view mirror and drive“!

The important lesson from history is that you cannot learn from history. We tend to over-emphasise the recent events of the immediate past, and worry about it. Look at the TV channels – they were all talking about the deluge on July 26,  this year too in Mumbai! Obviously July 26, 2011 could be a rainy day, a very, very, heavy rainy day – but on the other had it could be sunny!

When one looks at a fund performance, one will be guided by the past history, the true to label portfolio selection, the consistency of performance, etc. However, if you chase performance on the basis of its immediate past, you are likely to be sorry.

There is enough literature to show that equities are an excellent long term instrument and very volatile short term investment. Equities outperform other asset classes and vis-a-vis inflation. In the Indian context if you invested in the index in say 1978-79 and reshuffled it regularly (what an index fund would have done if it were available) your portfolio or Rs 100 would today be worth Rs 19,900. This is an excellent rate of return that one can hope to get.

So what exactly have stocks returned? Studies show that stocks have returned about 19.2% per year from 1980 through 2007. This number however does not include the dividends reinvested. In the US of A the dividend reinvested was TWICE the rate of appreciation. I have not come across any such study in India (would love it somebody can share it with me). Any return should be broken up into inflation, dividend and appreciation / capital gain.

Does this mean that stocks have returned 19% per year in most years? Hardly, the volatility of stocks is legendary. Markets returned a figure as high as 266% in 1992 and followed it up with a 46% fall in 1993. Thus the word average return does not make any sense for a volatile asset class like equity. Historically, we have never had a 4 year bull run! Three good years have been followed by one bad year!

But this is also an outlandish statement. Statistics is to be used very, very carefully. It is useful to use it to analyze rather than predict.

Talking about average in equities is like saying yesterday the air conditioner was not working, today it is freezing – so on an average we are comfortable!

However, what is clear is that the probability of making losses is almost (!!) nil in case a person chooses a balanced fund, managed by a good manager (fund house), does an SIP and stays invested for say 10 years at least.

This wide disparity of returns makes holding stocks for long periods of time a better idea than holding them for short periods.

If you are  interested in steadier, more predictable returns, let`s take a look at bonds, which tend to fluctuate less than stocks. As a rule, bonds cannot protect you against inflation. Let`s look at RBI bonds. It pays you 5.6% return (after tax) in a country where inflation is around 7%. When your adviser says, on an average you can expect to get 19% return over the next few years, what should you do?

Baulk! Predicting is difficult especially if it is about the future (Mark Twain). Surely this 19% return is fine, but the total return on an equity share (therefore a fund) is a function of how much dividends you get, what is the inflation rate, and the capital appreciation that you can expect. If your advisor does not know that, you need to read and equip yourself for meeting him!

What are the takeaways from this?

For long-term money, equities remain the best investment. They will not (perhaps cannot) return what they returned what they did over the past 5 years, but other asset classes cannot be compared to equities. Other asset classes like say Debt funds protect your capital and give reasonably good returns but not much inflation protection.

Manage your emotions, which may be the most important part of investing. Lynch says the amount of money you make is not a function of your IQ, but a function of the strength that your stomach muscles have! Can you take a churn?

Well diversified funds, index funds, unit linked equity funds (which by definition have a long term horizon) should all be in your wish list.