3 essentials of equity investing

By Larissa Fernand |  29-08-16 | 
 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

The biggest fear in investors’ minds when they consider equity as an investment, is the fear of getting wiped out. Hence, “buyer beware”.

A while back David Blanchett, head of retirement research for Morningstar Investment Management, conducted in-depth research on equity as an asset class. He looked at historical returns in 20 different stock markets across the world, at time periods from 1 to 20 years, and different levels of risk preference. The aim of the study was to look at time diversification-- that stocks change in terms of their riskiness over time.

The conclusion was that for individuals with a long-time horizon, stocks may be the least-risky asset of all. They deliver better returns and long-term capital gains tax is nil. Ironically, people think of cash as being a safer investment for longer time periods. But cash does not beat inflation to help create wealth. Over 10 to 20 years, stocks are a better investment versus cash or bonds. Last year, a Morgan Stanley report on Indian investments stated that equity delivered the best returns over various time periods. Over a 20-year period, equities returned 12.9%, gold 8.4%, bank fixed deposits 5.5% and property 6.2%.

So if you're someone with a very long time horizon, stocks actually may be the least-risky asset of all, even though it’s kind of counterintuitive.

Check out India's stock market. On January 1, 1990, the Sensex closed at 783.35. On New Year’s Day in 2016, it closed at 26,160.90.

Over this span of time, the stock market would have witnessed some gut-wrenching volatility: Persian Gulf crisis (1990), Harshad Mehta scam and global recession (1992), Asian financial crisis (1997), dotcom meltdown (2000), the India-Pakistan stand-off that brought both sides close to war and the Ketan Parikh scam (2001), the 9/11 terrorist attacks on the Twin Towers in New York (2001), war in Iraq (2003), the political uncertainty in 2004 which saw the Sensex slip from 5,400 (May 13) to about 4,500 in four days, global financial crisis (2008), the eruption of the European debt debacle (2010), and the weak macroeconomic fundamentals that ingrained fear even in the most diehard equity investors (2013).

Over these decades, the volatility would have been tremendous. After all, bull markets rarely age gracefully and bear markets cause anxiety attacks. But over these 26 years, investors who held on for the ride would be sitting on a nice pile of wealth. An investor who invested in the Sensex on January 1, 1990 would have made an absolute return of over 3,000%.

One of the keys to being a successful equity investor is not to flee when the ride gets rocky. A few years ago, at the Morningstar Investment Conference held in Mumbai, Scott Burns, then the director of fund research at Morningstar, made a very interesting observation with regards to investor behaviour. He explained that investors feel the pain of a loss of investment twice as much as they feel the pleasure of the gain. This is the reason they flee from equity the moment the ride gets turbulent. Instead of riding through the storm, they opt out with losses. This is detrimental to an investor’s portfolio and a prime cause for disenchantment with equity.

Investment guru Howard Marks, in one of his memos, explains why investors can invest in the best of companies (or a great mutual fund) and have a bad experience. He pins it down to investor psychology.

Consider this. Economies rise and fall quite moderately. Companies see their profits fluctuate much more because of operating and financial leverage. But market gyrations make the former look mild. Why do the prices of stocks rise and fall much more than profits? The answer lies in the dramatic ups and downs in investor psychology.

Investors get crazily bullish and imagine no limits on prosperity, growth and appreciation. At other times, they get despondent and conclude that the “worst case” scenario they prepared for isn’t negative enough. This causes them to get into the market only when it is on a roll and panic and sell when it falls. By doing so, they defeat themselves.

When investor Jean Marie Eveillard was asked to describe the characteristics of a good investor, his response was “the capacity to suffer”. Money manager Thomas Russo  popularised it.

A smart investor must have the ability to suffer though periods of bad performance. For instance, if the manager of an equity fund sticks consistently to his investment style, there would be periods when his portfolio is terribly out of favour relative to the forces that are driving the market at the time. You will be able to stay the course if you have the “ability to suffer”. And you can have that only if you invest for the long haul and have a strong thesis as to why you have invested in that fund in the first place.

Do remember, a significant portion of risk in equity comes from the behaviour of investors. So guard against that.

To encapsulate, here are the three learnings for an investor.

  1. Over the long term, equity is not risky.
  2. Short-term volatility in equities comes with the territory. Don’t have a myopic view of it.
  3. You are your own enemy. When the market falls, the losses are just paper losses that will not materialize unless the investor sells.
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