Consider this: two individuals take a trip to Delhi at different times. One visits the city in the scorching month of May and comes back complaining about the extreme heat. The other visits in the cool month of December, recounting tales of a refreshing winter chill. Both these experiences, contradictory yet accurate, fail to provide a comprehensive picture of Delhi’s weather throughout the year. The same phenomenon can be seen in the world of investments. The outcome of an investment is highly dependent on when you ventured into a specific stock or fund, impacting the returns. Two investors can have completely different experiences despite having the exact same investments at different times.
The pitfall of basing your investment decisions mainly on the past returns of your portfolio becomes evident when the investment timelines for various funds therein differ. In such a scenario, one fund may seem to be performing significantly better or worse than the others, which may be solely dictated by when you made the investment. Interestingly, you may even find dissimilarity in returns within your portfolio from the same fund, managed by the same person, solely because of the timing of the investment. Moreover, two different funds may have entirely different market cap structures, leading to a discrepancy in their short-term performances when compared directly.
Many a time, investors may review their portfolios and single out a few schemes that seem to be underperforming compared to all the others. This occasionally leads to the wrong conclusion that these schemes are ‘not working’. In reality, the underperformance is usually because of starting point bias. Let’s illustrate this with an example. If you invested in a liquid fund on March 23, 2010, a decade later, by March 23, 2020, you would have achieved an annualized return of 7.98%. In the same span, the Nifty 50 TRI delivered an annualised return of 5.13%. An inappropriate interpretation might suggest that liquid funds delivered a better profit over a decade than the Nifty did. But this is a misconstrued notion, as choosing specific start and end dates may not be reflective of the bigger picture. In most other 10-year windows, equities have easily outperformed liquid funds.
When assessing a scheme, it’s best to separate one’s personal experience from the exercise. Rolling Returns can be an effective tool to somewhat neutralize the aforementioned starting point bias. Rolling returns evaluate an investment’s success over numerous overlapping time frames, giving a more comprehensive outlook of its consistency and efficiency throughout various market cycles. For example, daily rolling one-year returns would denote the performance of the investment over 365 days, with each new calculation beginning one day after the last one. In essence, if you were to calculate one-year rolling returns for a fund from 2010 to 2020, you’d essentially be charting the fund’s performance for each subsequent year and then analysing the cumulative results.
One substantial benefit of rolling returns is the elimination of the bias that comes by choosing a particular starting point. Since all possible initiation dates are considered in rolling returns, the chances of the result being influenced by fortune are significantly reduced. Moreover, rolling returns can provide a clearer picture of the scheme’s consistency. By analysing how often the fund has outdone its peers or benchmarks, an investor is able to determine whether the returns were the result of consistent performance or mere occasional spikes.
Another important aspect that rolling returns shine a light on is a fund’s volatility. By illustrating the variance between the best and worst returns over different spans of time, investors can better ascertain the potential risks and predictability of the fund. This knowledge goes a long way towards managing expectations, as rolling returns, by showcasing a spectrum of potential results rather than a fixed number, prepare the investors mentally for potential highs and lows.
Going back to the Delhi travel anecdote, the concept of rolling returns would be similar to those two friends visiting both in May and December, but staying throughout the year to witness the full cyclical change of Delhi’s weather. This would enable them to paint a complete picture of Delhi’s climate. Similarly, for an investor, implementing the method of rolling returns and perhaps employing the expertise of a qualified advisor can bring more structure to the evaluation process, as well as prevent emotionally driven decision making.
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