The behaviour gap: Why investors earn less than the funds they own

Thesudden winds of change in the sentiment in Indian equity is an amalgamation of multiple factors, materializing almost simultaneously. The very reasons that caused the headwinds have turned to tailwinds. The temporary relief in crude prices, growing political opposition against AI infra build-up which resulted in questioning the AI trade, dollar dip and the return of FIIs (Foreign Institutional Investors) gave a fillip to the Indian markets in the past week.

One of the investors called me in the morning suggesting we book profits as stocks have rallied up. I was aghast at the thought and said that these’re just green shoots and possibly could sustain if the geopolitical situations don’t deteriorate. I understand hispredicament, but I dissuaded him from taking any action, for now.For investors who have been battered with bad news after another, this is not just a whiff of fresh air but a boost to their sagging morale.

And particularly during prolonged time corrections like that happened over the last two years, it tests the nerves and questions our conviction and premises. Usually, it squeezes the weak hands out.So, when we look at the average fund performances during this period - many of them have notched better than the market returns - versus the average investors returns, we notice a gap.

This difference between the returns a fund generates and the returns investors actually take home is defined as the ‘Behavior Gap’. This is because most investors chase winners and infuse fresh monies in funds which had recent best/better performance (buy high) and conversely pull their money out after the fund suffers a drawdown (selling low). Consequently, the returns earned by the investors in that fund is relatively lower than the fund’s reported return for that period.

This behavior is the financial equivalent of driving by looking at the rearview mirror, rather than what lies ahead. And the consequences can be devastating.

Consider a fund with an average annualized return of 12% over a ten-year period. An investor who remains invested all through this period experiences a similar return subject to timing and nature of cashflows. However, another investor who enters during a strong rally, exits during a correction and subsequently re-enters after the recovery could end up with significantly lower returns.

While both investors had access and exposed to the same fund, the same fund manager and the same investment strategy, the difference wasn’t the investment avenue but the investor’s behavior. Investors often spend umpteen hours evaluating fund managers, comparing rolling returns, analyzing portfolios. Yet very little attention is paid to the one crucial variable that has a direct bearing on the outcome and their wealth creation: their own behavior.

Corrections happen in two ways: price and time. A sharp correction can be unsettling, but it also brings clarity. It’s an immediate visible event to respond as portfolios shrink, markets fall and valuations turn reasonable or attractive. A time correction on the other hand, is far more insidious. When markets move sideways for months and even years, investors begin the opportunity cost of remaining invested. Every other alternate asset, geography or investment theme begins to look more attractive, making it difficult to resist a switch.

Of course, it’s already taken a time to notice that portfolio is going nowhere while the alternative proving its worthiness. The switch now would make good in the immediate period where one may enter as the rally picked up or peaking and only to figure out that it is turning unsustainable. By then the original investment would turn attractive or rallying back. The irony is, this behavior results in abandoning an investment just when its relative prospects are about to change.

One should acknowledge and recognize that markets are non-linear, and leadership rarely remains constant. It’s influenced by business cycles, market cycles and economic cycles, liquidity, sentiment, etc. which mayn’t favor the fund all the times. But, it’s the tendency of the investors to extrapolate the recent performance into the future, betting yesterday’s winners to continue.

Markets reward patience, not constant activity. This doesn’t mean investors should blindly hold on to every underperforming fund or ignoring flagging fundamentals. There’s a huge difference between performance-related disappointment and a fundamental breakdown in the investment thesis. A change in the fund management, persistent style drift, diminishing portfolio quality or a continued deviation from the stated mandate may warrant a review. Switching merely because the fund underperformed in the past few quarters is not ideal.

A well-constructed portfolio is designed to accommodate periods of discomfort. If investors abandon every component that temporarily underperforms then they risk dismantling the very diversification that was intended to protect them. The solution then is not in identifying or predicting the next winner but to build a process that reduces the friction of emotions impacting the decisions.

It’s important to have an investment plan even before committing an investment. The review mechanism can be periodic but appropriate. Rebalance instead of chasing performance. Top of all, understand thyself i.e., why investing at the first place, define the goals, analyze risk tolerance, stick to the timelines, and build a portfolio that represents you.

The recent improvement in sentiment is a reminder of how quickly market narratives change. The same factors that weighed today could turn supportive tomorrow. The objective is not to become immune to market movements but to avoid reacting to every market movement. After all, the difference between the returns markets deliver and investors earn has less to do with the market and more to the investor itself. The author is a partner with “Wealoctiy Analytics”, a SEBI registered Research Analyst and could be reached at [email protected]

ABOUT THE AUTHOR

K Naresh Kumar

K Naresh Kumar[email protected]