Volatility Worries.

Knowing that I am involved in the stock market (even though in a rather peripheral way) many acquaintances often pop the question “So which stock looks good today?”. My standard answer to this is that I only purchase mutual funds by availing of the Systematic Investment Plan (SIP) facility and that I usually do not buy individual stocks.

In the rare case when I do mention a stock or two worth purchasing, I notice that very few of them actually follow my advice. On being asked for the reason, there are two standard comments which I hear. One, “I want to buy but these are such uncertain times for the stock market. I am waiting for things to settle down before I purchase anything”. The second one (loosely related to the first) is “The market is too volatile for my comfort right now”. I get the same response even when I suggest that they commence investing in a few good equity mutual funds through the SIP route.

I think such people will be waiting forever. Volatility will remain a permanent feature in stock markets. Stock prices are the distillate of two primary stimuli : company & macro-economic fundamentals and human sentiment. The advent of internet trading, the rise of business channels, blogs and better communication facilities mean that any perceived change in fundamentals is quickly acted upon by the large mass of traders. The share of human sentiment in stock price determination is rising steadily. Everyone is out to squeeze out the last bit of returns through the use of every trading technique possible. When several traders behave in a concentrated way, prices are bound to react in a more magnified manner.

But this is no reason to stay away from stocks. After all, despite the heartburn that they often give in the short term, they are still the best vehicles for a lay person to participate in the country’s growth. As investors we can only try to manage this volatility either by purchasing stocks at reasonable prices or through modes such as SIPs and Value Averaging. Complete avoidance is neither possible nor desirable, as the non-volatile investments such as fixed deposits and bonds usually offer a very low yield post inflation and post-tax. Besides, there are many studies, both, in India and the USA which have shown that longer the holding period, lower the volatility.

Finally for those who are adamant on investing in stocks only when everything looks good, I can only think of Warren Buffett’s quote “You pay a very high price in the stock market for a cheery consensus”. Also, in a lighter vein I tell them that volatility is zero, only over the weekend when the stock market is closed.

How long is long term? Should one take a SIP?

I was talking recently with a couple who are our clients. The couple wanted to invest regularly for their children and were looking for alternatives. Since they were just starting off and the amounts were relatively sdirect equity investment was not very practical and hence I suggested Systematic Investment Plans in Mutual Funds. They were somewhat skeptical. They said that their experience with SIPs had not been too good.

Now there may be some subjectivity here because they (like most people) did not know the exact capital invested and the annualised returns that they had got. They only knew that the returns were “not very good”. It could be a case of wrong interpretation of returns, excessive expectations, bad choice of mutual fund schemes etc.

However it got me thinking. What if someone had invested in a SENSEX index fund on a SIP basis? What would have been the experience? I have taken SENSEX instead of NIFTY as it has a longer period for which to make calculations. I have ignored dividends as they would go towards asset management charges, entry loads etc.

The first chart indicates the terminal value if a SIP has been done for Rs. 10,000 every month starting in various months from 1979 to 1999 and ending 10 years later from 1989 to 2009. This would involve a capital investment of Rs. 1,200,000 (Twelve lacs) or 10,000 multiplied by 120 months.

The terminal values would range from Rs. 120 lacs to Rs. 10 lacs. At Rs. 10 lacs terminal value obviously there would be a loss since Rs. 12 lacs would have been invested.

 

The annualised yields from 10 year SIPs would range from +43% p.a. to -3.6% p.a.. Obviously a very large and unacceptable range for financial planning purposes. A long term investment horizon and a Systematic Investment Plan would not be a fail safe formula in many cases.

 I had a re-run of the investment performance assuming a time horizon of 20 years. The results here were more heartening.

The chart below indicates the terminal value if a SIP has been done for Rs. 10,000 every month starting in various months from 1979 to 1989 and ending 20 years later from 1999 to 2009. This would involve a capital investment of Rs. 2,400,000 (Twenty four lacs) or 10,000 multiplied by 240 months.

The terminal values would range from Rs. 252 lacs to Rs. 77 lacs. Even at Rs. 77 lacs terminal value obviously there is no loss since only Rs. 24 lacs have been invested.

The annualised yields from 20 year SIPs had a much more acceptable range from +20% p.a. to + 10.5% pa. A long term investment horizon of around 20 years and a Systematic Investment Plan would most likely not result in hardship for investors.

So what are the lessons from this exercise?

  1. Long term as is normally understood is an underestimate. The Government classifies an investment more than a year as long term. The investment professionals sing virtues of having a long term investing horizon defined as a 3-5 years horizon. I would propose that an investment horizon of around 20 years would be truly long term!
  2. Long term is in reality not very long. Considering the fact that a person joining employment at the age 25 and retiring at 60 spends 35 years waiting to grow a retirement corpus or the fact that a new born will go to college around 15 and join a business school at 20 or get married between 25 and 30, in our lives the goals that we want to achieve are sufficiently long for equity investments. 
  3. While market timing does not make sense, valuing the market may be very important. If one were to avoid investing at times of bubble and actually reduce equity exposure and increase equity exposure in down markets, the results would be dramatically different.
  4. Avoiding some perennial value destroying sectors would also improve the results dramatically. 

Points number 3 & 4 are subject matter for further calculations and a future post. Happy investing!