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How to become a prudent investor?

Published on Mon, Apr 02, 2007 at 17:36 | Source : Moneycontrol.com

Updated at Sat, Apr 07, 2007 at 14:05

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Past Performance and Maximum Returns are the two most dangerous terms in the world of equity investing. However, understanding these concepts well will take you one step forward to becoming a prudent investor.

"I want to maximize my returns". I cannot say how many times I have come across this statement when I ask people their objectives. I am sure most of the readers of this article might have this objective in their mind. (Also read - How to profit from Mutual Funds?)

Mutual Fund Houses through agents, distributors, advisors, and advertisements in personal finance magazines, billboards and television tend to do a rock show of their past performance. It's sad to know that the core focus of mutual fund advertising is past performance and yet it's the only thing that these funds cannot sell and investors cannot buy. Can the fund sell you a 40% return p.a of the last 5 years for the next 5 years? Clearly the answer is 'No'. So what does a fund mean when it suggests a 40% performance in 5 years? Does it mean that the next 5 years are going to be similar or even closer to this? Though we all know the answer to this, somewhere these past figures influence our decision and help us focus only on the returns part of the equation.

Now ask the same person about his risk tolerance or specifically "How much short term loss can you tolerate to achieve your objectives" and the answer can be from 0 to 10% depending on whom you are talking to. People cannot digest the fact that there can be short term loss when investing in equity but in reality it can be as high as 35-38% as we have all witnessed in May 2006 and 20% in a few weeks recently or more as amply demonstrated in 2000 technology meltdown. You will have read it several times that time in the market is more important than timing the market. In the short run, equities can go up and down but in the long run and in an era of growth & opportunity, equity will go northwards. Therefore it is very important to take stock of your Investment Time Horizon. It is one of the most important variables that will help determine how much money you should allocate to equity. (Also read - It's only time in the market that matters)

Author Jeremy Siegel in his book "Stocks for the Long Run" has the following table and an explanation of the table contents.

Table: Portfolio Allocation: Percentage of Portfolio in Stocks Based on All Historical data:

Risk	Holding Period
Tolerance	1 year	5 years	10 years	30 years
Ultra-conservative (Minimum Risk)	7.0%	25.0%	40.6%	71.3%
Conservative	25.0%	42.4%	61.3%	89.7%
Moderate	50.0%	62.7%	86.0%	112.9%
Risk-taking	75.0%	77.0%	104.3%	131.5%

The above table indicates the percentage of an investor's portfolio that should be in equity based on the investor's risk tolerance and time horizon. Several classes of investors were analyzed right from the ultraconservative who demand maximum safety no matter whatever be the return to the aggressive who is willing to take additional risks for extra returns. If you read the table carefully, you will see that the recommended equity allocation increases dramatically as the holding period increases. Even the ultraconservative can have around 3/4th of his/her portfolio in equities if the holding period is 30 years or more. Conservative investors should have nearly 90% equity exposure for a 30-year or more holding period and aggressive investors can have more than 100% exposure to equity. This allocation can be achieved by borrowing or leveraging an all equity portfolio. (Also read - Mutual Funds: Your best personal Portfolio Manager)

This does not mean that you should have the same asset allocation as given above. An individual's asset allocation will vary according to his liquidity need, goals , risk profile and time horizon. So opt for one that gives you an ability to sleep well during turbulent times.

And finally do not give undue importance to PAST PERFORMANCE.

There are two track records for any investment. The first one that is flashed everywhere has just ended, and hence it is known as the PAST PERFORMANCE. It can only tell you how the fund has performed in the past several weeks, months or years and the risks the fund manager has taken to achieve those returns. But it cannot tell you anything about it's future performance. The second track record will start the moment you invest your money. This is the only track record that matters and is important to you, and it may or may not be similar to its past performance.

Just because you have earned fabulous returns in the past following a mid cap strategy does not necessarily mean it will fetch the same results. But somehow our mind is trained to believe that this is going to be the case and decisions are generally based on this theory.

One of the statements that I have come across in a book on Wealth Management makes a brilliant statement "Uncared wealth is one risk you can't afford. Money has plenty of natural enemies-inflation, politics and ignorance". To this list I add my two paise (read cents) "Past Perfomance and Maximum Returns".

- Amar Pandit

The author is a practising Certified Financial Planner. He can be reached at amar.pandit@moneycontrol.com

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