We have been emphasizing that investors tend to have cognitive biases and irrational behaviors when investing stocks. Actually, investors are also biased when investing equity funds.
Let me ask a question first: would you redeem a fund in the following situations?
1. The fund lost 8% in 9 months and performed similar to CSI300 index.
2. The fund underperformed CSI300 index by 20%.
3. The fund’s NAV fell 25% from the peak, while CSI300 index went down 33% for the same period.
4. The fund lost 5% first half of 2020 and underperformed CSI300 index by 7%.
All of the above are real cases happened to a real fund in past 7 years. If investors redeemed in any of these situations, he/she would miss a great deal of return as in each situation the fund’s NAV hit new high afterward and made gross return near 500% in 7 years. This case indicates that short-term performance is not a valid reason to redeem a fund.
What behaviors will cause losses?
1. Conformity Effect
We’ve observed investors behaviors of our funds, and we found that the subscription volume surged when the market is hot and vice versa. Human instinct is to follow the crowds when making decisions, as people would experience much less phycological pressure if they act in the same way, however. It’s not the right way for investment timing.
2. Recency Effect
Our brain weights recent events much more than older ones. Media and financial advisors prefer to recommend funds that recently outperformed their peers, because these funds are eye-catching. However, to a great extent, short-term performance attributes to randomness and would deviate investors from its target of accumulating wealth in the long term.
3. Seeing is Believing Effect
Every investment has its potential risk and returns. You might feel safe or less risky when invest a fund with upward trend recently. However, investors often underestimate those potential risks that are not being seen and therefore take too much risks. This is why many investors can’t achieve good returns.
4. Sell the Winner Effect
Many investors tend to redeem a fund when they have 20%-30% return, and then wait for a perfect timing to invest next one. However, it is very difficult to time the market and many investors missed more future returns just because they want to sell and keep the current profits. Like the examples we mentioned earlier, if an investor redeemed the fund when he/she got 20% returns, he/she might miss the chance to double or triple their returns.
What is a good fund?
The purpose of investing is to accumulate wealth in the long term rather than in a single year or even a few months, so a good fund needs to help you achieve this goal. Also, the maximum drawdown should be controlled, which is an indicator that the fund manager has the ability to manage risks. Meanwhile, low maximum drawdown can help investors psychologically, and encourage them to hold fund for longer time.
There are many funds that can outperform others in a year, but only a few can last. Our research shows that less than 1% equity mutual funds achieved 15% compounded annual return from 2010 to the end of 2019. It’s not easy task to find future winners and achieve long time investment goal.
Three Principals for Investing in Equity Funds
Principal one: Observe long-term historical performance.
Many fund investors make investing decisions by following recommendations of friends or financial advisors, often ended up buying popular funds. However, just because a fund is popular does not mean it can bring you good long-term return, or a low max-drawdown. Investors need to observe a fund’s long-term performance through bull-bear market cycles and different market style shifts. Though the past performance does not necessary guarantee the future, a fund that did survive different market cycles and achieve excess return has a much better odds to obtain alpha again in the future.
Principal two: Know your fund manager’s investment style and philosophy.
Fund managers have various investment styles and philosophies, so you need to find a manger that fit your goal most. A fund manager could be aggressive or conservative, could prefer value or growth, and could be skilled at quantitative or subjective methods. The key is to verify whether the fund manager’s investment style and philosophy can help him/her achieve good performance in the long term.
For example, if a manager’s good performance comes from single sector or industry, would he/she be able to dig out opportunities in other sectors in the future? This question can be answered by his/her investment philosophy.
Principal Three: When facing volatility, hold on to your funds.
The market volatility is inevitable, and no fund can avoid it. For example, China A share crashed three times in 2015, triggered melting-down twice in 2016, plummeted in 2018 for Sino-U.S. trade dispute, and plunged again for the Covid-19 pandemic in 2020. If you have invested fund(s) based on the principals we mentioned above, you should hold on to it no matter how low the market goes.
Short-term performance caused by randomness is not the reason to redeem a fund. To accumulate long term wealth, you need to hold fund(s) for long time. Only redeem your funds when they no longer fit the first and second principals.
In order to help clients to hold our fund in challenge market conditions, we strive to communicate with investors in various ways. I have been writing Letter to Investors every quarter for a decade, and started to do live broadcasting to our clients and distribution channels in last couple of years. Those efforts are aiming to give clients more confidence to hold our fund in difficult times, and it is one of the reasons our clients have relative long average holding periods.