Reblog: How incorrect assessment of returns can lead to bad investment decisions
When it comes to gauging the worthiness of an investment, investors often land way off the mark. Most treat short-term returns as a yardstick, while others have unrealistic expectations. Yet others misinterpret returns completely. However, correct assessment of performance is a must to avoid bad investment decisions.
For most investors, point-to-point return figures serve as the performance yardstick. This can be misleading. The current return profile of equity funds, for instance, is a case in point. The three-year returns of most equity funds comfortably outshine the five-year figures (see chart). Large-cap funds have clocked 13.5% CAGR over the past five years compared to 17.8% over the past three. Mid-cap equity funds have yielded 20.6% CAGR over the past five years against a whopping 34% in three years. To the lay investor, this sharp disparity in returns poses a dilemma—if the return is so much higher for a three-year period, does it make sense to stay invested for five years or more? But the investor is overlooking two critical elements here. First, he is considering a singular point-to-point reference from the past to make an assumption about the future. Second, he is ignoring the difference between annualised returns and simple absolute returns.