Any investments made on the basis of a high near-term performance is fraught with the risk of an impending downturn. It is hence critical to examine the base case for investment in bull markets.
Euphoric times call for a balanced investment approach. As wise investors put it, ‘the seeds of investment mistakes are sown in a bull market’. The constant talk of extraordinary returns lulls investors to believe the party will last long. This moves them to a point where undue risks are taken, without a clear understanding that equity, or for that matter even debt markets, work in cycles.
Raging bull market
In a raging bull market, historic performance of most investments look good. A rising tide takes all in. In such a state, it is easy to fall prey to the lure of historic returns. Investors find it comforting in the belief that they are allocating to an instrument that has done well in the recent past. However much the disclaimer points out that past performance is not indicative of future returns, human minds are attuned to seek the immediate past. In a similar vein, should markets turn the other way, there is always an aversion to allocate monies, in the fear that markets can erode further. Typical investor mindsets are attuned to be bullish when there is euphoria and turn pessimistic on any change in environment. Such investor behaviour is normally termed as ‘Rear View investing’, where allocations are made basis the immediate past returns. As Warren Buffett once said, ‘In the business world, rear view mirror is always clearer than the windshield’. Investors get very excited in bull markets and make the recurring mistake of looking into the rear view mirror, regardless of overvaluation. Investments in small caps, now through vehicles such as closed end funds and Portfolio Management Services, based on past performance are very likely to disappoint in the future. If you look at long periods of market history, you tend to see returns tend to converge to a mean. Small caps have done extremely well in the last few years with gains far exceeding large caps and chances are this category would underperform in the next few years.
Past market movement
An observation of historic returns clearly shows that market cycles typically do not follow a linear pattern. Normally, a sharply rising phase is followed by a market that trends down or stays flat. Any investments made on the basis of a high near-term performance is fraught with the risk of an impending downturn. It is hence critical to examine the base case for investment in such bull markets. It is essential to identify trends in earnings growth, GDP movement, overall global scenario, etc., before committing money. In a highly interconnected world, events that happen far away have the ability to turn tables in our markets. Expectations of returns on the basis of a rear view of high returns can turn to disappointments. A number of funds are being raised on strategies having ‘profitable’ back testing results. However, as compared to the past, there are many more complex factors at play now and the same strategy’s level of robustness will differ in this era of automated and high volume algorithmic trading. To sum up, the worst ten-year period for any back test would be the next 10 years
Rear view with a twist
A patient investor can look forward to periods of negative sentiment in the environment to capitalise on the opportunities. Periods of under-performance invariably result in better times ahead. Should investors adopt a strategy of a reverse rear view investing, they are likely to be handsomely rewarded. Chances are that as bad as the immediate past performance appears, the greater the attraction to invest. Of course, one needs to keep in mind the economic factors as well. While rear view investing is the easiest to practise as the mood in the markets is positively charged, it takes a lot of guts and discipline to go against the tide and invest when the chips are down. It is to the disciplined investor the rewards are showered the highest. The worse your rear view returns are, the better are your chances of making above normal returns going forward.
The author is principal, Investment Advisory, Entrust Family Office Investment Advisors