“Past performance is not an indicator of future performance” — the literature of every mutual fund you own, mentions something to this effect.

In fact once, when I was lecturing at a mutual fund house, which was not performing well, one of the managers said, jocularly, “Can we say our past non-performance is not an indicator that in future we will not perform?”

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.

Wall Street stock investor, Peter Lynch sums this up well; he says“You cannot look in the rear view mirror and drive.“

History is…history! An important lesson from history –  you cannot learn from it!We tend to over-emphasise the recent events of the immediate past, and worry about it. When you look at a fund performance, you will be guided by past history, the true to label portfolio selection, the consistency of performance and so on. 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 in the short term. Equities outperform other asset classes, and vis-à-vis inflation.In the Indian context if you had 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 of Rs 100 would today be worth Rs 18,000.

This is an excellent rate of return, to hope for.

How to calculate stock returns

Studies show that stocks have returned about 19.2% per year from 1980 through 2006. This number however does not include the dividends reinvested. In the USA the dividend reinvested was twice the rate of appreciation.

Any return should be broken up into:

– Inflation

– Dividend

– Appreciation/capital gain

The buzzword: Long-term or average?

Think long-term. 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 four-year bull run! Three good years have been followed by one bad year – that is to say March 2008 has to end at a sensex figure less than that of March 2007.

But this is also an outlandish statement. Statistics are to be used very, very carefully, to analyse 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!

But what’s 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. So, where do we place our bets?

A thumbs down for this bond

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%.  That, effectively is a negative return of 1.4%.

When your advisor 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, the inflation rate, and capital appreciation that you can expect. If your advisor does not know that, you need to read and equip yourself before meeting him!

Investment wishlist

a. For long-term money, equities remain the best investment.They will not (perhaps cannot) return what they returned over the past five years. But other asset classes cannot be compared to equities.

b. Other asset classes like say debt funds protect your capital and give reasonably good returns. But they are not protected against inflation.

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

The final word:

Manage your emotions (this 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?