How to make great return from Equity Market?
Today, I have got a very interesting and useful mail for investors. It has appeared Outlook Business magazine. It is article about art of compounding. I am going to just share with all of you.
Why is the average investor confused by equities? And why doesn’t he earn anywhere close to fair returns from his investments? It’s not rocket science: equities are a remarkably simple asset class, in fact. But in the 20 years that I have been in the markets, I have lived through three major cycles — and in each one of these, the majority of investors mistimed their investments. That’s, in fact, a very disturbing statistic.
As the Sensex went up from 3,000 levels in 2003 to a peak of above 21,000 in January 2008, before ending close to 15,600 levels in March 2008, net sales of equity mutual funds increased from just Rs 118 crore in FY03 to Rs 53,000 crore in FY08. Since then, in down markets and at lower P/E multiples over the past four years (FY09-12), cumulative flows into equity funds have been negative Rs 6,000 crore. In simple terms, when P/Es were high, more than Rs 50,000 crore worth of equity funds was purchased in one year and when P/Es were lower, nearly Rs 6,000 crore worth of equity funds was sold or redeemed by investors across the country.
That’s a basic, return-unfriendly approach to investment so it’s really not surprising that most investors aren’t satisfied by the return on equities. But in an all-too human way, they blame the market when it’s their investment strategy that needs work. And as long as they continue investing disproportionately large amounts after strong past returns and at high P/Es and investing close to nothing after poor market returns and at low P/Es, investors will continue to gain less from equities and will continue to feel dissatisfied.
They’re certainly going about the same way even now, going by the current lack of flows in equity funds for the past several quarters and, in fact, some redemption. Albert Einstein summed it up very nicely: “Insanity is doing the same thing, over and over again, but expecting different results.” But why do otherwise astute individuals show such poor timing when it comes to equities? In my opinion, the key reason is that a majority of equity investments are done with a short-term view, despite the fact that the best equities have to offer is only over long periods.
And by taking a short-term view, investors miss out on what Einstein referred to as the “eighth wonder of the world” — the power of compounding. Just think about it: at 15% CAGR, 1 becomes nearly 2 in 5 years, 5 in 11 years, 10 in 17 years, 20 in 22 years and so on. Returns from equities mimic economic growth in nominal terms (real growth plus inflation) over long periods and, thus, equities have a high compounding potential, particularly in high-growth economies such as India.
But instead of targeting meaningful returns over long periods from compounding, most investors due to improper understanding of equities, target only small gains over short periods. As the investment horizon is short term, the focus is on guessing near-term market movements. This inevitably leads to extrapolating the markets in either direction and, therefore, in rising markets, the expectation is that markets will keep on rising. The greed for quick returns leads to higher inflows in equities and as the trend sustains, confidence and greed levels keep on increasing, leading to even larger inflows.
But instead of targeting meaningful returns over long periods from compounding, most investors due to improper understanding of equities, target only small gains over short periods. As the investment horizon is short term, the focus is on guessing near-term market movements. This inevitably leads to extrapolating the markets in either direction and, therefore, in rising markets, the expectation is that markets will keep on rising. The greed for quick returns leads to higher inflows in equities and as the trend sustains, confidence and greed levels keep on increasing, leading to even larger inflows.
Similarly, in downward-moving markets, investor expectation is that the markets will keep on moving lower, leading to lower inflows. The lower the markets move or the longer the markets do not move, the greater is the conviction among investors that markets will fall further or that markets are going nowhere, resulting in drying up of fresh investments or even redemption of existing investments.
Also, when markets are moving up, the news flow is generally good and vice versa. Therefore, generally, in rising markets the perceived risk is low whereas the actual risk is higher as valuations are high. On the other hand, in adverse times, when the markets are not doing well and the news flow is not good, the perceived risk is high whereas the actual risk is lower as valuations are attractive.
The net result is that, time and again, a majority of investors end up investing large amounts at high valuations and small amounts at low valuations. Clearly, such an approach to investments is not conducive to generating good returns and if followed, is likely to lead to disappointing results time and again.
A practical approach to investing
While no approach is perfect, it would be better if investors base their investments in equities not on news flow or past returns but simply on P/E multiples. Investors should practise low P/E investing with a long-term view — that is, investments in equities should be steadily increased as long as the P/Es are low. It sounds simple but isn’t — low P/Es are typically available only in adverse environments, when the news flow is negative, when markets have not done well and when the sentiment is not good. In such an environment, fear of losing money prevents a majority from investing in equities. Subjecting yourself to a plan of staggered investments in a low P/E environment or SIPs should be effective in at least partially overcoming the handicap of poor timing by investors.
Market outlook
Equities are hard to forecast over short to medium periods but are fairly reliable over long periods, more so in a secular growth economy such as India. Past experience suggests that P/Es tend to move between 10 times and 12 times at the lower end, and between 20 times and 25 times at the upper end. The journey from bottom to peak and back again takes considerable time (a cycle) and investor patience at lower P/Es is well rewarded over time. At present, though the markets are up 25% from the lows, keep in mind that the markets are lower compared with levels seen in 2007. In this period of five years, the economy has grown, profits of companies have increased and multiples are lower than long-term averages. Further, interest rates are likely to move lower and this is also supportive of higher P/Es.
It is no doubt true that the economy is still facing challenges, notably of high fiscal and current account deficits. But, I believe, the worst of these is behind us and the current year and the future years should see a steady improvement. Investors should maintain or increase allocation to equities in line with their risk appetite and with a long term view.
Here, it may be worthwhile for investors to keep in mind Sir John Templeton’s comment: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.” In May 2012, we had mentioned that pessimism is all that one sees all around. Things have changed since then. I believe we’re now in the scepticism phase. So you know what to expect next.
Feel free to ask any queries related investment
Regards,
Arvind Trivedi
Certified Financial Planner
(Article by Mr. Prashant Jain, Chief Investment Officer, HDFC Mutual Fund This article first appeared in Outlook Business magazine, Jan 05, 2013.)
