Four Misleading Investment Metrics To Watch Out For
The world of personal finance is replete with confusing jargon that can make the average investor's head spin! To make matters worse - even the way that investment returns are represented can sometimes be misleading. Here are five such metrics to be careful while considering.
Absolute Returns
"XYZ" investment has delivered a 349% return since inception", says your advisor. While this number can look impressive prima facie, it is in effect completely meaningless due to a vial missing element - the time frame in question. If the investment product in question is 15 years old, for instance, this figure really translates to a fairly mediocre long-term annualised return of 8.7%! For any time-horizon exceeding a year, make sure you consider the CAGR of "Compound Annualised Growth Rate" instead of absolute returns.
Exponential Growth Timeframe
In a way, this misleading metric is the exact reverse of the "absolute return" metric. This is best illustrated with an example. Take, for instance, the real estate investor who tells you that the value of his property has gone up "five times" since he purchased it in 1998. Or the insurance agent who lures you into a single premium plan that guarantees that your money will "triple" by the time you retire in twenty years. Both scenarios sound impressive to the untrained ear; but all it takes is a back of the envelope calculation to figure out that the annualised returns from both these scenarios are just 8.3% and 5.6%, respectively!
Return as a function of something other than your fund value
Certain kinds of Life Insurance plans (the ones that are touted as "traditional" plans) represent their annualised returns in a very interesting way. Say, you've taken up a 10-year policy with an annual premium outlay of Rs. 1 Lakh and a Sum Assured of 10 Lakhs. These plans will represent your 'returns' as a percentage of the Sum Assured, and not of your out of pocket contribution! For instance, your first year 'return' from this plan may be a bonus of 4% of the Sum Assured or Rs. 40,000 which, prima facie, appears to be a monumental 40% return. There's not one but two catches here, though! First. the 'return' will continue to accrue on your Sum Assured throughout your policy - so goodbye, compounding. Second, this Rs. 40,000 cannot be withdrawn by you until the end of the policy, which may be several years of decades hence. In a nutshell, your returns from such plan will likely not even be inflation beating.
Historical Returns
I recently read a book which advocated investing most of your money into small cap stocks for a decade or more, because they have much higher historical returns. However, it may surprise you to know that hardly anybody would have actually ended up earning these returns in real life, unless they had invested money in small caps and completely forgotten about them for a decade! Recommending investments based purely on historical returns is a gross oversimplification which basically ignores the 'behavioural gap' between published historical returns and actual average returns earned, on average, by investors. The more the volatility, the deeper the behavioural gap. When considering historical returns, be sure to also consider volatility measures such as standard deviation, as well as the 'worst year' returns earned by the product.
