The dangers of chasing rising asset classes

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Investors should not be encouraged to invest in a trending asset class if it does not match their risk profile

It is a mistake to chase rising asset classes and a mistake investors fall for most often. In the words of Warren Buffett, you have to be a little greedy when others are fearful and a little fearful when others are greedy. However, it is not uncommon to see the brains of investors willing to invest money in an asset class that has been performing well lately. This behavior, called “recency bias”, is the human tendency to assume that recent trends will continue. Investors looking for short-term returns fall into the trap of investing in winning asset classes.

Historically heavily hunted asset classes end up falling back, shortly after a majority of people have taken the plunge. Investors should understand that various asset classes go through cycles and if an asset class has generated supernormal returns in the recent past, the same trend is unlikely to continue in the future.

Understanding the fundamental drivers of the performance of various asset classes is the key to investing at the start of a bull cycle to maximize returns. For example, the perfect time to invest in gold was in 2018, at the very beginning of the uptrend. At this point, future returns were not visible, but what was visible were the following factors affecting gold prices, constant sustained demand from central banks and global investors, geopolitical uncertainties due the US-China trade war and Brexit coupled with the relatively poor performance of equity and debt have been conducive to an increase in demand and price for this safe haven asset.

However, the returns obtained by investors vary depending on when they choose to invest in the yellow metal. Chasing the safe-haven asset when it had already grown significantly resulted in below-average returns. If an investor had invested in gold at the start of the bullish cycle in October 2018, they would have achieved handsome returns of 59.15% in absolute terms by the end of 2020. If the same investor had invested in April 2020 at first look at the yellow metal as there was a sharp increase in global and domestic demand, it would have generated absolute returns of only 15.64% in 31st December 2020. For investors who jumped the wagon when the yellow metal touched Rs 50,000 for the first time on the 29the June 2020, their investment would generate only 3.31% by the end of the year.

Currently, we are seeing the same trend for international funds. The returns of the last 2 years have been fabulous and given that the Indian investor who had historically always preferred to invest in the domestic market now wishes to invest in international funds. But most don’t realize that if the long-term average is 10-15% and the returns for the past two years have been 20-50%, the next few years would mostly see an average return. Moreover, from a fundamental point of view, such high returns are not sustainable over a much longer period. Therefore, we believe that diversification into Indian equities is a good addition to the portfolio, but clients should enter with limited allocation and moderate expectations.

This race for performance can be dangerous for an investor’s wealth. This can cause investors to buy high and sell low as they direct their corpus or cash flow to trending asset classes. This could interfere with financial and retirement planning, putting the investor at financial risk. While this is a natural tendency to seek past performance, it becomes inevitable as the financial media tends to encourage this behavior by highlighting investments that have performed well recently. In the case of most financial instruments, the disclaimer “past performance is not indicative of future performance” is very important. Therefore, investors should consider their risk profile, short and long term financial goals before looking for asset classes or other trending financial instruments.

The only solution to this is prudent asset allocation. As 11 players on a cricket team play their positions well to ensure the team wins, investors should treat their assets the same. The portfolio should be constructed in such a way as to ensure that each asset class plays its respective position to ensure financial stability and wealth creation through various market cycles. Investors should not be persuaded to invest in a trending asset class if it does not match their risk profile or long term goals.

The author is responsible at Anand Rathi Preferred

DISCLAIMER: The views expressed are those of the author. Outlook Money does not necessarily subscribe to it. Outlook Money will not be liable for any damages caused to any person / organization directly or indirectly.


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