Friday, December 19, 2008

The Biggest Mistake Today

There are a lot of hoary old clich├ęs about learning from mistakes. Starting roughly at the time when we enter school, we're subjected to preaching about how one should learn from one's mistakes or that one should learn from others' mistakes or even that one can't succeed without making mistakes and so on and so forth. We are always told that mistakes make excellent teachers. All this may be irritating but it's also true, at least in financial matters. 

For the last few years, we've all gotten used to a situation where it felt as if those mistakes didn't matter. All types of investments were doing well, all kind of assets were rising in value and most people's real (non-investment) earnings were rising rapidly too. If you had money in a bottom-quartile mutual fund, you still made good returns. It just happened to be less than you would have made otherwise. If you had neglected to think of asset allocation and all your money was in risky mid-cap stocks and sector funds then that were OK too–you got better returns than any safe strategy would have got you. Even if you were committing the ultimate sin of borrowing to invest–perhaps in a piece of land–that was OK too because the money was cheap and the returns plentiful.

Unfortunately, those times are gone now and its time to focus on correcting mistakes. It's often said that to save wisely and invest well, one doesn't really have to do any big thing right. Instead, all that is needed is to avoid making mistakes. And so, as these bad times threaten to turn into worst ones, it may be a good idea for all of us to focus on the financial mistakes we've made.  

There's a deeper mistake that has driven the investors' behavior on the stock markets. And this nothing but the same old bogey, short-termism. A year ago, everyone was pouring money into stocks because they wanted to catch every bit of gains that could be had. As those gains turned into losses, investors ran away and pulled out as much money as possible out of stocks. Now, no matter what happens, they are not going to invest till… well, I don't know till when. On the surface, this seems like sensible behavior. The markets have turned negative, so people have pulled out.

In reality, it's anything but. What we were doing a year ago was also short-termism, and what we are doing now is also short-termism. It is true that business prospects around the world appear to be bleak. However, it is also true that stocks already have a fair bit of bleakness priced into them. Sooner or later, things will turn around, and specific parts of the markets will turn around quicker than others. When this will start happening is clearly uncertain. However, the whole point of making money on the stock markets is to have a long-term view so that you can buy when everything is down in the dumps and available dirt cheap. I'm not saying that its time to rush back in, but continuing with regularly investing, whether its through a SIP plan or otherwise is the right approach. Those who have stopped investing in this mania are not doing the right thing.

If this is not the time to start doing that, then it will never be!!

Thursday, December 4, 2008

Profit from the Great Panic of 2008

Now is possibly the most stressful situation that Indian equity investors have ever faced. 

Let's take a look at what we've said in the past, and how the Great Panic of 2008 reinforces the principles behind our advice. Here's a summary of those unchanging principles. 

- Investors should not need to time the market. Therefore, the only valid investing approach is one that is always the same, regardless of market conditions.

- At any point of time, all the money that you need within three to five years should be in fixed income assets.

- Long-term money should be allocated between fixed income and equity depending on your ability to take temporary losses.

- Whenever the balance of this allocation changes because one asset type has earned more than the other sell one and buy the other to restore the balance.

- Never invest large lumps of money in equity. Do it gradually, SIP style. 

Any investor who has followed this advice is sitting pretty today, largely unaffected by the Great Panic. The market value of your investments may be down today, but since you don't need any of it for many years to come, that doesn't matter. Long before you'll need the money; it would have had a chance to start growing again.

Today, the natural response of many investors to what we're saying is that right now, they've lost money. They say, “The returns may come back in the future, but what about the losses that I've made today". Those who say this are right in their arithmetic, but completely wrong in their assumptions. The only way to avoid the occasional crash is to be able to see the future, and if you could see into the future then you wouldn't be reading this any way. The whole point of investment approach that we are advocating is that it eliminates the need to see into the future. 

The Past Proves the Point  

The actual track record of the past decade shows that this approach works quite well. If you had started investing Rs 20,000 a month in a Sensex-based index fund in early 1997 and had continued to do so without regard to the ups and downs of the market, then today your rate of return would have stood at 14 per cent per annum. In all, you would have gradually put in Rs 28.6 lakh and these investments would have stood at Rs 66 lakh today, after the crash.

During this period, many mutual funds have comfortably beaten the Sensex so the Rs 66 lakh is a rather conservative figure. In a median fund, the 10 years would have seen your nest egg reach about Rs 1.04 crore. And this, during a decade which has witnessed two huge market crashes!  

That's after absorbing the hit of the worst panic that anyone has ever seen, when the market is at a long-term low point. Once any kind of recovery commences, the value is very likely to shoot up. If this isn't a perfect demonstration for the value of our slow-and steady way, then nothing can be.  

Over such a long period, the so-called 'safe' fixed-income avenues do so much worse than supposedly 'unsafe' equity, that the there's no contest at all. Over this same period, you could have earned an average of no more than around 8 per cent per annum in fixed income investments. The same inputs would leave you with just about Rs 44 lakh, which doesn't cover even the inflation rate adequately.

The moral of the story: Despite the crashes, equity is the far safer option over the long run.  

The real danger to your financial well-being is not market crashes, but from the insidious affect of inflation

Crashes are Your Friends

In the equity markets, you make more money not despite the crashes, but because of the crashes. Let's modify the above story with the assumption that the post-tech crash of 2000-2001 never happened. The way that crash actually happened, the Sensex reached a peak of about 5,900 in February 2000. It then crashed and went as low as about 2,600 in September 2001. It then started rising and reached the previous peak of ~6,190 again only in January 2004. 

Let's assume that the crash never happened. The Sensex reached 5,600 in March 2000 and then stayed at that level till October 2004. If that had happened, then your Rs 20,000 a month would be worth Rs 55 lakh instead of Rs 66 lakh! That's right. For the long term investor, the crash of 2000 was worth a lot of money.

How did you make more money because the crash? The answer is obvious to anyone who understands the basic arithmetic of what's happening here. The crash enabled you to buy cheap and thus eventually raised your total returns. If you are investing steadily for the long-term, then intermittent crashes help you make more money, not less.  

And that is how you will eventually profit from the Great Panic of 2008. Stocks are now cheap, and are probably going to get cheaper. The longer and deeper this crash, the more money you will eventually make. If you know what's good for you, you should be praying that the Sensex falls to maybe 6000 or 7000 and then stays there for a few months or years before coming to life again. 

And that's the secret of equity investing, the real moral of the story: For the long-term investor, equity is not good despite the occasional crash. It's good precisely because it crashes. 

Volatility is your friend. Volatility is what will make you rich.