My friend Hetal, is very good at ‘trading’ in the stock markets.
She does technical analysis, uses derivatives and makes a great profit once in a while. She occasionally does badly too but my guess is, she mostly fares well.
She genuinely believes that she is better than any fund manager in the world. One day I asked her, so what is the average rate of return you think you make? Pat came the reply - ’25 percent’. And how long have you been doing this? ‘25 years’. How much did you start with? A mere Rs 1 lakh, she says.
Okay, now, here is some math: If your portfolio grew at 10 percent every year and if you reinvested that 10 percent every year and took the advantage of compounding, then in 25 years, your portfolio should have grown approximately 11 times. So, let us say you started with Rs 1 lakh, 25 years ago, that would have grown to approximately Rs 11 lakh. That is, (11-1)/1= 1000 percent return.
Now, if Hetal’s portfolio grew at 25 percent for 25 years, and the compounding happened just annually (not monthly or daily and so on), her money should have grown approximately 265 times.
It is safe then, to deduce that she has not really grown at 25 percent compounded annual growth rate (CAGR).
Repeat after me. “The most important lesson in investing is humility” - Sir John Templeton.
So, do you think she was lying? I suspect not. She is just a victim -- of a naïve, narrow vision that we all have, about money. Maybe, she does make that kind of return on 2 percent of the portfolio and feels happy about it and calls it her success rate, which it indeed is, but how much has her total corpus grown? I don’t suppose she will ever tell me.
Anyway, the point is, when one fund in the portfolio grows at an exceptional rate and some others don’t, we miss the BIG PICTURE. How much is the portfolio growing at?
Let us consider this situation:
Now, anyone has the right to feel ecstatic if they came up with the idea of investing in Fund A, but how much did the investor make on the portfolio? 5.5 percent.
This is exactly where asset allocation comes in, weightages come in and when a fund manager’s performance is measured, you must know that his ability to pick individual stocks is about as important as the weightages he assigns to them. But none of that now – let us focus on your portfolio.
Will you try and recollect how much money you had 25 years ago and how much do you have today? Now calculate how much it has grown at. Most of us don’t know how to do that, our incomes have gone up, we have added to the portfolio, redeemed for our needs – who the hell really knows. But, if it matters to you, do a back of the hand calculation.
If you come to even a high single digit number, congratulations on becoming rich! Or not? Oops.….To be continued.
This is the first part of the two-part 'On Becoming Rich' article series.
The author is the Founder of ABANWILL CONSULTANTS LLP, a firm that was formed to provide independent views on investing and make an impact in the field of Financial Services.
The thoughts and opinions shared here are of the author.
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