Credo Capital

Pareto principle or the 80/20 rule is fairly well known simply put it says  20% of inputs is responsible for  80% of results and vice-versa, which goes to show that most results are due to a small number of factors. This seems to hold good in investing too but with a twist.

IDFC mutual fund recently came with an intriguing ad IDFC Ad – want to loose money ( click for the ad)

The ad makes an interesting observation,

1. When markets are cheap ( ie they are down badly and it is a good time to buy) hardly 1% investors put money and this 1% investors make amazing returns over next few years (29% p.a is the return over next 3 years)
2. When markets are fairly valued ( they are not down but are not expensive either) around 19% investors put money to work and they get good returns ( ~ 19% p.a is the returns over next 3 years )
3. And when markets are over-valued ( they are up and expensive ) a whopping 80% investors put their money in and they see pathetic returns (hardly 3% p.a over next three years)

If you add the investors in 1 & 2 above it is 20% investors who make good money and 80% investors do not make money.

Why does this happen? Answer lies in our memory which is oriented to look out for only short term,

In stage 1 above when equities are undervalued, the news flow would be negative ( Ex : some crisis in Italy /high interest rates in India/ Recession in US or something like that) at this point in time the past return from equities too would be poor, so no one would be interested in investing except for the 1% and they are buying at the cheapest rate available for the next few years !!

In stage 2 some positive news is emerging  and past returns would be o.k but nothing great, at this point in some more investors come in thinking it is still fairly valued.

In stage 3: This is lift off stage, there is no dearth of positive news ( India GDP at all time high / ABC Group buys largest steel company in US / GLobal markets are up,etc), Last 3 years returns are a great 25% pa and business channels are saying this is a ” New era ” !! This is when even your uncle and his neighbour are heavily investing ( the 80% investors move in quickly seeing the past returns ) and both stage 1 & 2 investors become nervous &  don’t invest more. Anyone investing at this point historically is likely not to make money but that does not stop us from trying as we believe that the great returns of the past will keep happening, what happens instead is poor returns at best or loss of capital at worst. In 2-3 years after stage 3, Things will be likely back in stage 1 & history repeats itself.

The best choice for investors is invest via lumpsum in stage 1 & 2, even though it would be tough to do so when no one else is investing and stay put for 5 or 1o years, and avoid  buying near stage 3.

In this new financial year, here’s wishing that you are in the 20% who make good returns.