Finance for Everyone

In this series, it is my endeavor to demonstrate that Finance is 90% common sense & 10% fundamentals and it can be mastered by everyone. Most readers are interested in getting superlative returns on their investments and achieving financial freedom. The good news is that it is possible and one doesn’t need to be a financial wizard to do so. If you, the discerning reader, do not find it easy to understand my blog, please feel free to reach out to me with your feedback. I promise to make the necessary changes to simplify things further.

The Cost of Indecisiveness in Investing

The other day, I was talking to a friend of mine (Let’s call her Pooja) who was trying to get some perspective on investments. She had kept a significant chunk of her money in a combination of Savings accounts & Fixed Deposits where she was earning about 5-6% annually. When asked if she was happy with it, she responded that she was not and wanted to invest that money in Equity or Equity MFs but hadn’t made a decision. On further probing, I found that she simply delayed taking the decision as she felt that she may not make the right decisions and some of her decisions may end up losing money.  I told her that being indecisive is the worst thing that you can do and the cost of indecisiveness is much higher than average or downright poor decisions. But then I realized that without numbers, I would struggle to explain it to her and therefore my discussion went like this.

Me: Let me try to explain by giving some numbers. Let us say, we invested 5 lakhs today. Let’s split this into 5 blocks of 1 lakh each and we will take decision on each block now.

Pooja: Okay.

Me: Let me keep it simple. The first 3 blocks of 1 lakh will be invested in Large Cap Equity Funds or Index Funds only. If you go through the last 5 years returns, you will see that most of them have delivered 16% or higher. Choose any 3 MF Schemes that you like. Look at Value Research Morning Star or Moneycontrol etc. and choose 3 funds that have ratings of 4 Star or higher. Given that you will have many options, choosing 3 will not be difficult. Okay?

Pooja: Done. I have selected 3 that I like from those that were rated 4 stars or higher. However, if you question me, I won’t be able to tell you why I have chosen these 3 and not others.

Me: I am not going to question you on your choices. The fact that we are making a decision is good enough. How do you expect them to deliver in the coming 15-20 years assuming that you will stay invested for that period?

Pooja: I don’t know. Possibly all of them will deliver an annual growth of 10-16% over that time frame.

Me: Let me paint a bleaker picture than that. Let us say that only one Asset out of three is able to generate an average return of 16% over the years. The other two assets will deliver an average return of -10% & -16% respectively.

Pooja: This is a bleak enough picture. You are in effect saying that only one will turn out okay and the other two are disasters. I am sure the outcome won’t be as bad as that.

Me: Let’s go with it for the time being. Let’s now decide on the other 2 blocks of 1 lakh each. Let’s select 2 Mid Cap funds. Can you select 2 Mid Cap funds with 4 Star or 5 Star ratings?

Pooja: Done. I have selected 2 Funds.

Me: Let me now paint a scenario for these 2 Funds. Only one Fund will deliver a 25% average annual growth while the other delivers a -30% over the investment horizon.

Pooja: What you are telling me is that, out of five choices only two will turn out along expected lines and the other three are disasters. In effect, my success rate is only 40% and the remaining 60% of initial investments are lemons delivering negative returns ranging from -10% to -30%. Will that not be terrible for the final outcome? I am sure the portfolio will look pretty bad.

Me: Let’s take a look. I have constructed the portfolio as per our assumptions and this is how it looks.

Pooja: You are telling me that despite my poor success rate of 40%, my 5 lakhs will grow to Rs.1.06 crores in 20 years. My portfolio CAGR in 15 years & 20 years is 14.5% & 16.5% respectively. That’s strange, I thought with 3 disastrous decisions, my portfolio would be in very bad shape.

Me: Let me explain why it is that way. The world of investing where money gets compounded works in a way that works beautifully for the risk-taker.  Successes are amplified while failures are abridged. Look at Asset 1 & 3, Asset 1 is growing at +16% while Asset 3 is declining at -16%. Asset 1 in 15 years has grown from 1 lakh to 9.26 lakhs while Asset 3 has declined from 1 lakh to Rs.7315. In a sense Asset 1 has grown by 8.26 lakhs while Asset 3 has declined by 0.93 lakhs. If you look at 20 years, the difference is even more stark. Asset 1 has grown by 18.4 lakhs while Asset 3 has declined by 0.97 lakhs. 

The key point is that gains and losses are not symmetric.  Look at Asset 4 & 5: Asset 4 is growing at +25% while Asset 5 is declining at a faster rate of -30%. But after 20 years, Asset 4 has gained 85.7 lakhs while Asset 5 has lost 0.99 lakhs. The outcome of Asset 5 is undoubtedly disastrous but Asset 4 growth has delivered a reward that is disproportionate. In Asset 4, as you earn interest on the initial investment and accumulated interest, the growth accelerates. Conversely, as you experience losses as in Asset 5, the value of the investment decreases more slowly over time.  To put it simply, if you win you win big and if you lose you don’t lose nearly as much as you win.

If you look at the portfolio as a whole, the CAGR is 16.5% after 20 years even though three investments out of five are disasters while two have delivered along expected lines. This is an example of the real power of compounding as it allows you to be wrong 60% of the time but still enables you to make handsome returns over time.

Had you left 5 lakhs in assets that generate 6% annual returns due to indecisiveness, it would have grown to only about 16 lakhs after 20 years. However, the decision to invest despite a 60% error rate has a chance of becoming 1.06 crores. I hope you understand now why the cost of indecisiveness is higher than the cost of making wrong decisions. So go ahead and make a decision. You will be glad that you did.

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Authored by: Prof. Subhasish Acharya, 17^th April 2024, NCU School of Business