Engineering, physics, chemistry are all guided by laws, there is very little controversy. Finance on the other hand is guided a lot by human behavior. For every convincing explanation there is an equally convincing rebuttal. It’s one of the greatest shows on earth, what’s not to be fascinated!
‘For higher returns’ is the most-oft received response. And that’s a good answer, there is enough evidence across all world markets to suggest that equities have out-performed other asset classes over long periods of time. INR 100 invested on 1st Jan’93 in the BSE Sensex is INR 2,600 in Sep’23 – that’s a 2500% absolute return with an 11.2 % CAGR.
My follow-up question is what do you mean by higher returns? Most experienced and savvy investors respond within a range of 12 – 15% CAGR. They have internalized the power of compounding – it’s not just an academic concept – they also understand that this range is not easy to achieve over long periods of time. Legendary investor Warren Buffet is often quoted as saying, “My wealth has come from a combination of living in America, some lucky genes and compound interest”. And while that may be a very humble statement, as you cannot take away his remarkable astuteness and flare, it’s not very far from the truth.
However, many of us, look towards equity markets for returns that are unrealistic. When anyone gives an out of whack expectation, I like to remind them that Berkshire Hathway’s incredible performance is an annualized return of 19.8% from 1965, until recently. Are you going to beat that? Yes, maybe you could, but let’s keep the probability realistic. Last 10-year returns of Indian Equity markets is a good benchmark to keep in mind when you are setting your expectations.
Last 10 Years Performance of Nifty 50, Nifty Midcap 100 and Nifty Small-cap 100
ET CONTRIBUTORSData as on 20th Oct 2023
Many investors however look towards equity markets for multi-bagger returns in a few months or days, making a quick buck and getting out, get-rich-quick stock tips. Many fear volatility and stay away from it, they think of stock markets as casinos, a place for gamblers and risk takers — if they enter they will lose and the house always wins.
I like to look at Equity Markets (on a very high level) as a boon of capitalism that allows each of us to own companies that impact and will further impact how we as humans live and how the world runs. It provides an amazing platform for participating in wealth creation to everyone, with complete freedom and choice in how much you want to participate and how.
Once expectations of overall returns are settled, I like to ask – how do you think you will make this return over the years? Because the truth is many investors think that they will make 12 – 15% every year. It’s worth noting that neither Berkshire nor the S&P nor NIFTY for that matter saw many years where they delivered the average return, most years saw either massive gains or very disappointing losses. Long-term outperformance comes with many years of underperformance.
That’s the fundamental rule of how equity markets work. Volatility is part of the game, and during intense short-term volatility all equations can break, stock prices of good companies can fall as much as others and in times of exuberance prices of companies that are not so well run can rise higher than high quality companies. But our friend mean-reversion always comes through to smoothen the anomalies.
There’s a very interesting TED talk by Kelly McGonigal on how to make stress your friend. She argues that we all have stress, and have turned stress into our enemy and make all our efforts to eliminate stress. Whereas, she says those that do not get stressed at the thought of stress and make stress their friend, have the lowest health risks from it.
I would presume the same applies for volatility in the markets – if we accept that volatility exists and are prepared for it, in fact learn not just how to navigate it but also turn it to our advantage, we could generate exceptional returns from the equity markets.
We looked at the Indian Equity markets over the last 15 years, in phases of up and down moves. If you navigated the volatility and stayed put the markets delivered a 15% CAGR and a 6.7x absolute returns. The Non-linear nature of equity returns is the most critical aspect for investors to keep in mind.
ET CONTRIBUTORSData as on 30th Sep 2023
Dealing with Risk
We’re entering a period where risks seem to be on the rise. The Israel-Hamas war could spread into something bigger, impacting crude oil supplies and prices. The U.S. debt, $25 trillion and counting, remains a dark cloud over the global economy, and U.S. mortgage rates and interest rates have risen alarmingly of-late. The U.S. yield curve has started steepening, historically a harbinger of weakness. The Russia-Ukraine war continues. Domestic elections add an element of uncertainty and on and on…
Staying invested during times of rising risk can be uncomfortable. The lure of selling and exiting becomes tangible. We believe an evidence-based approach provides clarity and builds the conviction that is necessary, and information that provides a data-driven path forward. Fear can derail the best plans and investment mistakes at inopportune times can have painful consequences; however, familiarity with historical precedent, data and models allows for better decision making and acceptable outcomes.
For instance, a few months ago, in March 2023, SVB collapsed in the U.S. and for a few days, it looked like it would take the regional banking system under with it. Fear was rampant. Markets bottomed that month, and are up 16.5% since the March crisis. Mid and small caps have soared.
In October 2020, markets were worried about the very survival of the human race. Uncertainties around vaccines and COVID raged. Delta variant was detected in October 2020. Hardly a good time for markets. Yet again, risk was tangible. Three years later, the Nifty 50 is up 67%.
Similarly, in the fall of 2018, IL&FS defaulted and the fallout extended across the Indian banking system. Globally, U.S. China tensions were simmering. Global growth was slowing. It looked like a fairly dismal time to invest. Fear was high. Mid and small caps had been hammered that year. Five years on, the Nifty has almost doubled from Oct 2018 levels.
Many made the mistake of letting their fear drive an exit from the markets at these times. Those that looked at the data realized the India story had legs, bought growth and made substantial returns in excess of benchmark.
The Lure of Exiting
At times of uncertainty, investor behavior matters more than investment analysis. Human behavior often tends to flight during times of heightened fear. The ability to not deviate from plan, not sell during a panic, keep investing in growth assets on a regular basis is a time-honored means of achieving investment goals. Knowing yourself and how your behavior changes during times of stress, and aligning portfolios accordingly, is as important as knowing the fundamentals backing your investment holdings.
Aligning Portfolios with Worst Case Risk Tolerance
In most instances, asset allocation weights are decided when times are good, and investor appetite for risk is likely to be fairly high. We believe it is essential that portfolios are aligned with investor’s bear market risk tolerance. That risk tolerance is usually much lower. As risk tolerance declines during sell-offs, some investors commit the cardinal sin of capitulating at market bottoms. Far better to be allocated so that your emotions don’t get the better of you at the worst possible times.
Perspective Matters
In our experience, investors that view markets with a glass half-full perspective have generally been best prepared to navigate the volatility and generally experience the largest wealth accumulation. In addition, patience and taking a longer investment horizon view helps.
Second, investors that have conviction, a grasp on the fundamentals of their portfolio, the larger economy and trends, are able to navigate volatility and generate outsized returns.
Investors focused on loss of capital, timing the market and similar notions, inevitably or eventually make sub optimal decisions that can impact their long-term wealth creation potential.
To summarize, fear is loud and jarring. Evidence is boring. Fear brings worries about Black Swans, nuclear war, pandemics, terrorist attacks, market crashes. Market volatility is not a cause of worry, the actual concern is the volatility in our minds. Following a sound investing methodology makes it likely that you will make wise choices. Happy Investing!
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
