Risks Digest 30.40

As the general elections inch closer, and amid increased crude oil prices and rising interest rates, many investors—even with long-term investment horizon—in India are looking to curb their holdings in equity markets. In theory, this seems cogent, essentially being an attempt to bring into practice the eternal investment mantra of “buy low and sell high.” To take a practical example, let us assume that two investors deployed Rs 100 each in the benchmark BSE Sensex on January 3, 2000. One of them, being a long-term investor, waited patiently for 10 years. She would have been rewarded with a hefty gain of Rs 294 on December 31, 2010, based on eventual Sensex movement. The second investor—the smarter one—managed to sell her entire stock portfolio at a mid-cycle peak hit by the Sensex in September 2000. She was prescient—or fortunate—enough to redeploy her capital in September 2001 at one of the worst mid-cycle troughs in the decade.

Similarly, she was again able to sell her portfolio 12 months before the other largest-in-the-decade Sensex decline and to re-enter the market at the cyclical bottom in February 2009. This investor’s capital would have zoomed by Rs 1,033, i.e. 3.5-times of the first investor’s gain on December 31, 2010. However, there are three reasons why this investment approach—of stepping in and out of markets based on expectations of short-term market moves—is futile, unnecessary and impracticable, especially for long-term investors. First, it is extremely difficult to get the short-term market calls right given the multitude of factors—on global geopolitics, trade and economics, and country-level factors—involved. Indeed, more money can be lost in trying to anticipate market corrections, than is lost in the corrections themselves. While the above example—of the second investor who managed to exit and re-enter the market with impeccable timing—looks fairly simple and powerful, it has a bleak side, too.

Let us assume that in her pursuit for market peaks and bottoms, the second investor’s prediction went wrong. Instead of getting out 12 months before the two troughs, she exited 12 months before the two steepest mid-term peaks of the decade—December 2003 and December 2007—and re-entered after 12 months, i.e. at the peaks. In this case, Rs 100 invested on January 1, 2000, would have delivered a return of only Rs 127 on December 31, 2010, i.e. less than half of the first investor’s gain. Second, most market corrections are relatively short-lived. History provides some interesting insights here. The benchmark Dow Jones Industrial Index in the US has seen 11 key episodes with dips of 20% or more since 1900 (in 1907, post profit and productivity boom events in 1917 and 1920, “Kennedy break” of 1962, crisis of confidence in 1966, inflation shock of 1969, oil shocks in 1973 and 1977, black Monday and its aftermath of 1987, tech bust of 2001-02, and global financial crisis of 2008). On an average, these episodes witnessed a dip of 34% in Dow Jones Industrial Index over 15 months.

Post the dip, they took an average of 36 months to break-even. On this evidence, if an investor can digest 30-40% decline in her portfolio but can hold on for 5-6 years, then her dependence on short-term market movements may be marginal. The caveat here is that the Great Depression of 1929-32 and the Bear Market of 1937-38 are not included in the above list. It is important for investors to try to avoid, or to be prepared for market disasters like these two events. Such extreme events—driven by real, sustained collapse in macroeconomic systems—unfortunately are difficult to survive even for bottom-up, long-term, fundamental investors with patience and discipline. The saving grace here is that disasters of such intensity and duration occur with relatively low frequency.

Finally, if an investor is striving to create wealth by investing in stocks—and not in market indices—she need not fear short-term market volatility. There is clear evidence that movements in stocks can be quite different from, and actually easier to forecast over long-term, than the broader indices. Then, despite contrary evidence, why do even long-term investors try to pre-empt short-term market corrections? Loss aversion bias is the key reason. We are wired to detest losses much more than we like gains of similar quantum. Further, most of us suffer from overconfidence bias. It makes us believe that we have the ability to call even the short-term market fluctuations with precision. Social-proof bias is another reason.

On occasions when everyone—right from business news channels to experienced market hands—is highlighting concerns and enhanced market risks, it is not easy to avoid the trap. For a long-term investor, the key is to remain conscious of the above three cognitive biases. In the current context, as we enter an intensive, 12-month-long election season in India, it will be crucial to remember that election results seldom mark turning points for markets. The last three occasions when the incumbent government in India was defeated in the general elections, the market either had shrugged off the initial disappointment very quickly (in 1999 and 2004) or had cheered the results (2014). Similarly, oil prices had kept on rising sharply during 1998-2000 and 2004-07 when equity markets had been on a tear. History suggests that long-term investors can register healthy returns—unless caught in a prolonged bear market—by sticking to bottom-up fundamental style, without getting worked up regarding short-term market outlook.

Vipul Prasad

Founder & CEO, Magadh Capital

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