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"15%? That's kind of low, isn't it?" said the distinguished looking person to whom I had been explaining the arbitrage returns from the Indian markets. We were at a Diwali social gathering, and I did not really know him that well. I could only guess from his mannerisms and sophistication in social matters that he was also well educated about financial matters. The volatility of the arbitrage fund was only 2.5% annually, whereas the real estate prices can stay flat or go up by 25%. Also, it could be pointed out that the arbitrage fund is liquid any time you want, whereas converting the apartment into cash is no mean achievement. Overall, I could have gotten into a debate with him but the poker table was waiting, so I let it pass. That place or moment was not right to delve into the details of returns adjusted for risk, liquidity and total costs!
People tend to focus a lot on the returns and not on other characteristics of investments. The obvious primary concern besides returns should be the risk involved. Risk and return go hand in hand. We all understand that 10% from bank fixed deposit is not directly comparable with 20% from an investment in a mid-cap stock we heard from our brother-in-law. Risk is typically measured as variability of returns. So, the risk profile of a fixed deposit that gives an assured 10% returns is different from a mid-cap stock that could return 30% or lose 10%. However, the problem is that risk and returns for risky investments are not known upfront and have to be estimated. And we do not really do a good job of estimating the risk and expected returns. As the famous saying (variously attributed to Niels Bohr, Albert Einstein or Mark Twain) goes: "It is difficult to make predictions, especially about the future."
Famous researchers Tversky and Kahneman had shown way back in 1974 that people really make some major errors in estimation.
First of all, they are heavily "anchored" in their expectations. In the area of investing, anchoring can be to the most recent returns. So, if the stock went up 20% last year, we start with an assumption that the returns will be about the same again. Then we are incapable of making sufficient adjustments to the "anchored" estimate based on the information that we have or can easily get. For example, we would say that the returns should be plus or minus 5%. Historical records may show that the actual range might be from -30% to +70%.
The second issue is of liquidity. Most people are only concerned with the absolute returns and they assume that the money will be available as and when needed. Only in times of a crisis do we realise that having a lot of illiquid investments is not good if they cannot provide you the cash in time to meet your obligations.
Real estate investments may have returned 20% on an average over long periods but what would be your realised returns if you need the cash in a hurry? A lot of real estate developers have found out to their dismay that assets do not equal cash. Finally, the total costs. We need to take care of the transaction costs (for example the stamp duty in the case of real estate). What look like attractive returns may in fact be mediocre or even poor once you consider the total costs of transaction. The normal costs of brokerage, transaction and stamp duties must be considered. Even more important are the market impact costs. Market impact costs refer to the cost of getting out of a position. Let us say you own an apartment and want to sell it in a hurry to raise some cash. The price you will get will certainly be lower than the price you would get if you had some time to wait for the right buyers.
The difference in the realised price versus the fair price is the market impact. Similarly, when selling stocks, if you have to sell in a hurry and if the volume of the stock traded is not a lot, then the price will fall as you start selling. This risk is particularly large in small- and some mid-cap stocks. And, then, there are the taxes to be considered. Depending on whether you are going to pay long- or short-term capital gains, or even business income, can make a huge difference to your post tax returns. So, the next time someone tells you that a particular investment idea is going to generate 25% returns, ask them what are the risks, liquidity constraints and the total transaction costs.
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