28 September 2023
Understanding the intricate ways in which varying returns can impact your wealth is often a complex endeavor when navigating the world of investments.
Let's delve into two hypothetical scenarios to shed light on this matter:
In the first scenario, we have Investor A and Investor B. Investor A initiates their investment journey by placing Rs 10 lakhs into an Index ETF. Over the course of a decade, the Index exhibits a robust 15% Compound Annual Growth Rate (CAGR). Consequently, Investor A's initial investment swells to an impressive Rs 40 lakhs.
In contrast, Investor B chooses to venture into the stock market independently with the same initial sum of Rs 10 lakhs. However, they encounter a significant setback in the first year, suffering a 25% loss. Recognizing the mistake, Investor B subsequently shifts their strategy to align with that of Investor A. After a decade, Investor B's portfolio stands at Rs 26 lakhs.
As a result, after this 10-year period, Investor A boasts a 54% larger portfolio than Investor B. This stark contrast in outcomes can be attributed to two primary factors: firstly, Investor B incurred a substantial 25% loss in the very first year, and secondly, Investor B had only nine years to compound their wealth compared to Investor A's ten-year horizon.
Now, let's explore a second scenario. Imagine an investor who consistently achieves a 15% annual return over a decade by adopting a passive investment approach, focusing on Index Mutual Funds. Concurrently, there's another investor who adopts a more active investment strategy, yielding an 18% annual return over nine years. However, in the tenth year, this investor experiences a 10% loss.
The intriguing twist in this scenario is that the investor with the stable 15% annual return ultimately accumulates more capital than the one who earned higher returns for nine consecutive years. This outcome may initially confound expectations and defy common assumptions. Many individuals naturally assume that consistently outperforming by 3% annually for nine years within a 10-year timeframe should outweigh a single year of a 10% loss.
To truly grasp the significance of these outcomes, consider the power of compounding. After the initial nine years, Investor A, with a 15% compounded annual return on their initial investment of Rs 10 lakhs, finds themselves with a portfolio worth Rs 35 lakhs. Meanwhile, Investor B, with consistent 18% returns, amasses a more substantial corpus of Rs 43 lakhs after nine years. However, in the tenth year, Investor A continues to earn steady returns, while Investor B faces setbacks due to a few misjudged investments.
The underlying message here is clear: if you find yourself consistently outperforming the market, it's prudent to continue your strategy with cautious experimentation. Even a single year of poor performance can significantly impact your overall returns.
Dr. Anil Kumar Asnani
SEBI Reg. Research Analyst