How to manage your return expectations

By taking a step back.

Chasing returns is fraught with danger. We tend to chase because by nature we extrapolate time series. What happened in the past “must” happen in the future, or so we hope. Because a particular person/fund/manager had their portfolio return a certain rate over 2-3-5 years, we expect our very enrollment in that fund should start, the very next month, the “inevitable” time series that the past numbers implicitly “promised”.

Past returns are helpful to understand why some manager(s) may have had excellent security selection (the “right” businesses, at the right/bargain prices), the right proportions (having 2% of their fund go up 3x does not move the needle), and the role of luck. Any honest / self-critical fund manager will admit the help of the final ingredient.

Past returns tell us that the building blocks for relative out-performance exist with that fund manager.

Long periods of out-performance may well be followed by periods of underperformance. Some of the best value investors in the world exhibit this pattern. It is worth asking yourself – are you mentally prepared to stay calm & do nothing especially during the (inevitable) periods of underperformance? or have you created in your mind the (unrealistic) expectation that your fund manager(s) can never underperform & should consistently and always be outperforming a) the relevant benchmark & b) every other fund manager you know?

So when we invest with a fund, the first thing we should be doing is setting very realistic return expectations for ourselves – over a long period of time (ideally 5-10+ years). This is crucial to avoid a) disappointment & b) shopping behavior (my fund only returned X%, I know of a fund which did X+Y% – I should switch)

Developing conviction in the wisdom & abilities of your fund manager(s), before you invest – is essential.

That said, what are “realistic return expectations”?

For me, if I invest in one of the mutual funds, I’d be perfectly happy with 15% p.a. They may do better, but my bar is set at 15.

If I invest in one of the PMS services I respect, I would expect some outperformance relative to mutual funds & would set my bar at 20% p.a.

What’s not being captured in these simplistic expectations is a final, and most important ingredient – time T. The formula for compounding is A = P(1 + R)^T; The End Value “A” is determined not just by R but by T as well, and in fact, more by T than R.

I would want the funds to compound at those rates for a very long period of time – like 20-30 years. If you open up an excel sheet & do the math, 15% over 30 years is a rather high number (~66x), more than sufficient for financial security & possibly even financial independence much before the end of that long period. At 20%, the numbers (~237x) are still more staggering. The first takeaway is – we don’t “need” 30-40% type returns; if they come “once in a while”, well & good, but we must distinguish needs from wants.

Generating outperformance for a single year is very hard, and harder still over longer periods. The key is to minimize “down” years, as that really affects the rate of your networth growth. That’s the one crucial thing you also need to have conviction in – your fund manager(s)’ focus on risk management, and minimizing the downside risks.

There are two common situations which cause people to seek-out super-aggressive returns:

  1. They perceive their savings / net worth is “small” compared to other people they know/guess.
  2. They’ve come to the decision of allocating more to equities “late” in their life, and want to catch-up with lost time.

A dangerous (hypothetical) “solution”  : to go allocate 100% of their savings to a small-cap fund which has given highest returns last 1-2 years. (chasing). Small-caps tend to be riskier than mid-caps which tend to be riskier than large-caps. Going down the risk curve to satisfy one’s higher expectations for returns is likely to be a poor decision.

In value investing, risk and return are negatively correlated. You do not need to (and ideally, should not be) take more risk to have a higher return. The hunt is to find businesses at such compelling valuations that if you are wrong in your analysis, you only lose a little, but if you are right, you do very well. Minimizing down-side risk is key, and the job of a good portfolio manager.

Equities, if looked at the responsible way, is not gambling, and shouldn’t be thought of as a speculative “play”, a lottery ticket, or a “get rich quick” scheme. Your ownership & participation in equities is your family’s long-term asset.

When in doubt, stay conservative. Between longevity of reasonable returns and potentially high returns which may fizzle or worse, hurt –  we are always better off with the former.