Portfolio Ideas. Why absolute cash flows matter

Your happiness typically depends on how much wealth you have relative to your friends and family. We call it the relativity principle.

In this article, we explain why you should preferably not apply the relativity principle for your personal finance decisions.

Relativity principle

Suppose, you see a dress/shirt marked down 50 per cent to ₹3,000 at an end-of-season sale. Chances are, you will buy it. But you are unlikely to buy the same shirt if it were retailing for a regular price of ₹3,000. Buying a product at a discount increases happiness relative to buying it at full price. Now, buying products and services based on the relativity principle is not necessarily bad.

After all, consumption of goods and services is as much about our emotional satisfaction as about utility.

What has relativity principle got to do with your personal finance?

You are always looking for investments that provide higher returns relative to a benchmark, or ones that could increase your wealth relative to that of your friends’. But should you do so?

Suppose you are investing to fund your child’s education.

Your happiness depends on sending your child to her preferred college, not on earning higher returns than the NSE 50 Index.

Absolute cash flows matter, not returns relative to a benchmark.

Absolute flows

Yet, you derive more happiness investing in an active fund than an index fund. There is a parallel to your discount-sale behaviour.

Consider two scenarios. In the first scenario, you invest in an active fund that generates 10 per cent return when the NSE 50 Index gives only 9 per cent. In the second scenario, you invest in an index fund that generates 10 per cent return. You are likely to derive greater emotional satisfaction from the first scenario even though both returned 10 per cent. Such behaviour could be a cause for concern. Why?

Active funds are examples of investment products based on the relativity principle, whereas index funds provide absolute cash flows. The latter carries only market risk while the former also carries active risk. This is the risk that the fund manager could underperform the benchmark index.

True, there are managers who outperform just as they are those who underperform. The issue is that outperformance (or positive alpha) is as much about luck as it is about skill.

That is, good fund managers could underperform because of bad luck and not-so-great manager could outperform because of good luck. It is, therefore, difficult to distinguish between a good fund and a not-so-good one. What if you buy a fund that eventually underperforms? You could jeopardise your life goal. That said, you should invest in an active fund if you are confident about your fund evaluation process, for a skillful and lucky fund manager can give you higher returns when the market rises and lower losses when the market declines.

But if you are concerned about picking the wrong active fund, simply invest in an index fund.You should invest in bank term deposits for your bond exposure.

Both index funds and bank deposits deliver absolute cash flows. Remember, absolute cash flows matter, even for relative happiness.

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

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