One of the most complex aspects of personal finance is to choose among the myriad of investment options available. It is easy to mistake a complex, slickly presented product to be a better product. This post puts forward the view that the reverse is often true – a simple, easy to understand product is better. Often people find complex products exiting and simple products boring. We argue that in personal finance, “Boring is Better”.
This is a companion post to the India version of Harold Pollack’s Index Card – Pollack’s Index Card: All the financial advice that you ever need – India version. As originally stated, this point reads: Invest in lower-cost, equity mutual funds, before getting to individual stocks. The larger suggestion is: Look for more passive, simpler options before getting into active, complex options. Note: This post strays a bit from the tagline of the blog and is light on data and heavy on opinions.
The essence of the rule – Don’t compete with “Mr Market”, and his friends
Mr. Market is an allegory created by investor Benjamin Graham. Graham asks the reader to imagine that he is one of the two owners of a business, along with a partner called Mr. Market. The partner frequently offers to sell his share of the business or to buy the reader's share. This partner is what today would be called manic-depressive, with his estimate of the business's value going from very pessimistic to wildly optimistic. The reader is always free to decline the partner's offer, since he will soon come back with an entirely different offer. Since its introduction in Graham's 1949 book The Intelligent Investor, this phrase has been cited many times to explain that the stock market tends to fluctuate.
This post is not talking about equity markets alone. Many of the suitable investment products are market linked – be it debt, equity, commodities, etc. A section, possibly a majority, of the investors in India completely shun market products in the financial industry – they stick to conventional bank deposits and investment-cum-insurance products. On the other side of the spectrum, many investors get too deep and too fast into market products and make poor decisions.
While there are many, many possible examples, let us look at an equity example first. Even in a market product like equity mutual funds, there are a variety of funds with a broad range of volatility. There are funds that seek to outperform the market. And there are simple and plain index funds that track broad indices like Nifty 50, Sensex, etc. The index funds may give the exact returns of the underlying index, and this need not be bad at all.
To give an example in the fixed income space, many people get excited about (secured and unsecured) 10-year bonds, with market-driven interest rates, that have varying levels of credit risk. And there is the plain, old Public Provident Fund which is steady, some would call it staid or boring. For most needs, PPF would be a better product than many long-term bonds. (Please see this post for an argument on why every Indian should have a PPF account.)
For every invement need, there could be examples of this: Steady, boring approach vs Exciting, more active approach. To better appreciate why the steady approach is better, we should look at the concept of CRATON.
Corpus is more important than Return
Asan Ideas For Wealth is a well-administered closed Facebook group that is focused on personal finance. The admin, Ashal Jauhari, uses many acronyms in his interactions. (A full list is here.) One acronym that is very relevant to this topic is CRATON – Corpus Ready At Time Of Need. It is often used when people ask questions about some ‘exciting’ way to get more returns: “CRATON is more important than Return”. This statement has deep meanings. One interpretation would be this:
“I have a comprehensive plan for all my financial goals. I have selected investments aligned to the plan and I am investing regularly in them. I am on track to create the corpus I need for the goals. It does not matter if my neighbour is earning a better return on her investments. I am focused on building the corpus that I need, and ensuring that it is ready when I need it.”
What is the evidence that investors chase returns?
We have some spotty data points from India.
- The average age of a SIP is much less than 3 years
- Less than 30% of equity mutual fund AUM is in folios older than 2 years (Source: AMFI data )
In the US market, there is a systematic study on investor behaviour. It is now in its 25th year. Dalbar’s Quantitative Analysis of Investor Behaviour has consistently found that an average mutual fund investor performs worse than the S&P 500 index. A copy of the 2017 report is available here.
Since 1994, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds over short and long-term timeframes. These effects are measured from the perspective of the investor and do not represent the performance of the investments themselves. The results consistently show that the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest. The retention rate data for equity, fixed income and asset allocation mutual funds strongly suggests that investors lack the patience and long-term vision to stay invested in any one fund for much more than four years. Jumping into and out of investments every few years is not a prudent strategy because investors are simply unable to correctly time when to make such moves.
To drive this point further, a specific image from the 2017 report is included below. (Image Courtesy: Dalbar)
How does this prinicple work in real life?
Once you decide that ‘Boring is Better’, it is easy enough to apply. You just apply it to each asset class, and don’t compare asset classes.
- For long-term fixed income instruments, use PPF. Once the limit is exhausted, then look at long term bonds
- For short-term debt, don’t rule out Fixed Deposits (https://freefincal.com/has-it-become-impossible-to-choose-debt-mutual-funds/)
- For parking funds for 3-6 months, consider simple Savings account, and avoid liquid funds ( https://freefincal.com/choose-liquid-fund/)
- For equity, start with mutual funds first, and then consider direct equity
- For equity mutual funds, select funds that are suitable to your plan, instead of chasing the top-rated fund (https://freefincal.com/how-mutual-funds-beat-index/)
- Continuing this, start with large cap funds (and in particular index trackers), before chasing small cap funds, and sectoral funds
- For direct equity, look for steady gainers, instead of chasing ‘3 year multi-baggers’ (https://freefincal.com/select-your-first-stock-without-breaking-your-head-here-is-how/)
- and so on…
You would confuse yourself if you start comparing different asset classes. For example PPF vs ELSS, Mutual fund vs Direct equity, etc. are eternal debates that would have no clear winners.
- Pollack’s Index Card: All the financial advice that you ever need – India version
- Harold Pollack’s Index Card
- Dalbar’s Study – 2017 report (courtesy Surevest Investment Counsel)
- How To Invest Better & Why The Best Investments Are Boring