Summary of this article
Downside protection in mutual funds is crucial.
Recovering from big losses is hard.
Consistent mutual funds outperform flashy top performers over the long term.
If a stock or a mutual fund falls by 25 per cent from Rs 100 to Rs 75, it will need to rise by 33.33 per cent to return to Rs 100. Similarly, if a Rs 100 stock falls by 50 per cent to Rs 50, it has to go up by 100 per cent to reach its original value. If the same stock falls by 75 per cent to Rs 25, it will need to gain 300 per cent to recover to its original price, and if it falls by 90 per cent, it needs to go up by 900 per cent to recover.
This shows that the more you lose, the harder it becomes to recover your original price and thus the need to protect your investments from negative returns.
Legendary investor Warren Buffett has also emphasised the importance of downside protection in investing.
Rule No. 1: Never lose money
Rule No.2: Don’t forget Rule No.1.
Don’t chase the best mutual funds
Avoid chasing the cyclical best mutual funds. The top funds of today may not remain at the top in future. Instead, an investor should look for funds that have consistently performed well. Look at the table. The table shows two funds – Fund A and Fund B. While Fund A looks dull and boring, with an average of 11 per cent to 12 per cent returns in all five years, Fund B looks quite interesting, with returns as high as 25 per cent and 30 per cent in three out of five years.
But surprisingly, both the funds have delivered similar compounded average growth rate (CAGR) of 11.2 per cent for Fund A and 11.6 per cent for Fund B. You can see how the negative returns in two years out of five averaged down the returns of Fund B, which otherwise looked promising with high double-digit returns in most time periods.
So, as an investor, you don’t need to chase such funds which may come at the top in some years but fall heavily when markets are not favourable. Instead, look for funds which have produced average and consistent returns, like Fund A in the example above, across market cycles.
Don’t exit your mutual fund investments in haste
The longer you stay invested in equity mutual funds, the lower your chances of negative returns are. Look at the chart below. The chart shows the monthly returns as a short-term view and the long-term view of Sensex, the benchmark index that represents the largest 30 companies listed on Indian stock exchanges. The chart clearly shows how volatility eases in the long term as compared to the short-term period.
When you are an equity investor, you should be prepared for some volatility in the short term, but over the long term, that volatility cools off. According to a study conducted by FundsIndia, the chances of negative returns become zero if the investment horizon is seven years or higher. This study was based on the historical performance of Nifty 50 since its launch in June 1999. Nifty 50 is an index that represents the largest 50 companies of the country.
In fact, for an investment horizon of over seven years, chances of earning more than 10 per cent returns became as high as 84 per cent and 80 per cent of the the large cap index has tripled investors’ money in 10-11 years.
So, investing in consistently well-performing equity funds with a long term horizon of seven years or more seem to be a good recipe to avoid big negative returns in your portfolio. Downside protection will also keep you, as an investor, calm during the times of volatility. This will further help you to continue with your investments and make sound decisions when markets are going through stressful phases.
