Planning to pick winning portfolios? Past performance is not the only way to go!

Since COVID-19 began, Indian markets have seen a surge in young, DIY investors who enjoy building their own portfolios with stocks, mutual funds, and more. While this can be rewarding, focusing on isolated factors can lead to costly mistakes and even market abandonment. This guide will highlight key mistakes to avoid and present a 4-step framework for selecting portfolios that align with your goals and risk tolerance. The results speak for themselves when informed decisions are based on a solid framework.

Past performance is not the only way to go!

any investors choose mutual funds by sorting them by highest returns and picking the top 2-3. However, selecting top-performing funds based solely on past performance can lead to disappointment. Let’s explore why this strategy is flawed.

Why Base Period Matters

A common mistake investor make is focusing on past returns without considering the base period. The base period is the starting point for calculating returns. As shown, two portfolios (A and B) launched at different times can have significantly different returns despite similar strategies.

ETMarkets.comPortfolio A, launched in March 2020 during a market crash, shows higher returns than Portfolio B, which started in December 2019 before the crash. This disparity is due to the low base period for Portfolio A, not because it is inherently better.

High Returns ≠ Low Risk

Many investors assess risk using past returns, but risk and return are positively correlated, known as the risk-return tradeoff. High historical returns often come with higher risk and no guarantee of continuing. Thus, investors should consider both returns and risk factors when evaluating investments.

Tangled up in Biases?

Understanding the risk-reward relationship is crucial as it can be influenced by emotional biases. For example, seeing past high returns might tempt you to invest without considering the risks, leading to a FOMO Frenzy. This fear of missing out can cause impulsive decisions and following the crowd, which can be costly.

Beware of recency bias, where you focus too much on recent returns and ignore long-term trends. Don’t be misled by recent successes. Also, watch out for anchoring bias, where you base investment choices on past returns, expecting them to continue. Remember, past performance doesn’t guarantee future results and can make you overlook other critical factors and uncertainties.

A 4-Step Framework to choosing the right portfolio

Here’s a practical 4-step framework to guide you to choose the right investment portfolio.

1. Understand Your Risk Profile

This is the foundation of your investment journey. Assess your risk tolerance by considering:

Investment Goals: Are you saving for retirement (long-term) or a down payment on a house (short-term)?Time Horizon: How long can you stay invested before needing the money?Financial Situation: How much can you invest without affecting your financial stability?Emotional Response to Volatility: How comfortable are you with market ups and downs?Your risk profile determines the right asset allocation. A mismatch between your risk tolerance and your portfolio’s risk level can be costly.

2. Align Your Portfolio with Your Investment Theme

Consider the portfolio’s theme and ensure it aligns with your goals instead of investing in a portfolio because it has the highest returns.

3. Analyze Volatility and Risk-Adjusted Returns

Based on your risk profile, study the portfolio’s volatility and risk-adjusted returns. Volatility measures price fluctuations, while risk-adjusted return shows returns relative to risk. Here’s how to use risk-adjusted returns when selecting a portfolio.

ETMarkets.com