Finding a ‘good enough’ active fund

How to choose a scheme that will satisfy and suffice your life goals

No matter how often we discuss, readers have more questions on this. We are, of course, referring to queries relating to investing in active funds. Several readers suggested that we discuss a simple method of choosing active funds. Accordingly, in this article, we explore a behavioural process called ‘satisficing’.

Satisficing enables you to choose an active fund that is ‘good enough’ to achieve your life goal. That said, such a choice may not always be better than investing in an index fund.

Heuristics

All your investment decisions involve trade-offs. You could apply sophisticated financial models that you learnt in your graduate school to choose the best investment products that will enable you to achieve your life goals. But that would require hours of analysis and considerable amount of your personal time. Or you could spend just enough time to choose several ‘good enough’ investment products. Often, you will settle for the latter. And rightly so.

Your logical brain consumes a lot of energy to process information. And you require it to perform professional work.

So, your logical brain is tired by the time you sit down to analyse your personal finance during weekends or at night on weekdays.

When your logical brain is tired, your emotional brain automatically takes over. It searches for short cuts to arrive at a decision. Such short-cuts are called heuristics.

You may be already applying a heuristic for choosing active funds — for instance, selecting an active fund based on performance rankings on personal finance websites. You could choose a fund that is ranked among the top 10 large-cap funds based on three-, five-, seven- and 10-year periods.

The issue is that a fund that features among the top 10 on 10-year performance may be ranked beyond 20 on five-year performance.

Such varying performance across time-frames makes it difficult to apply ranking as a heuristic for choosing funds. So, what should you do?

Satisficing

Satisficing is a portmanteau of the words satisfy and suffice. The argument, put forth by economist and psychologist Herbert Simon, is that we do not analyse all factors and choices available to us while taking a decision. Rather, we typically choose a product or service that is ‘good enough’ or satisficing.

Settling for good enough means that you are emotionally comfortable even if the fund you choose underperforms its peers within the style class.

How can you choose a fund that will be satisficing? The answer lies in a heuristic called familiarity bias. You should choose an active fund that you are familiar with. You may be familiar with a fund because your friend suggested you invest in it or you read about the fund in a personal finance website.

You should check if the fund has consistently generated positive alpha in the last 10 years. If so, set up an SIP on the fund for a year. You should review your decision when you renew the SIP annually. Why?

Satisficing is not optimal, but it is good enough as a trade-off to optimise your personal time. But there is a caveat. Satisficing works well for decisions relating to products such as cars, laptops and mobiles but may not always for investment decisions. The reason is because the outcome of your investment decision is uncertain, whereas your actual experience with your car or laptop may be in line with your expectations. So, if you find that satisficing is not good enough, you should switch to an index fund instead of renewing your SIP. You can, of course, comfort yourself with the thought that you at least tried investing in active funds.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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