Saturday, March 27, 2010

Are Equity Markets that risky??

There was an American comedian who, whenever someone would ask him, "How's your wife?" would reply, "Compared to what"? The answer to today's big question is the same. Is equity investing too risky for the retail investors? Well, compared to what? The crucial issue is not whether the investor is retail or wholesale, but whether the investments are for the long- or the short-term and what kind of skills and presence of mind does he or she brings to the actual choice of investments.

Practically speaking, risk in the stock markets is a function of time. The longer the time frame over which you invest, the lower the risk. Today, all this talk of the 'retail investors' losing money in the markets appears to be about individuals who normally do not invest in the markets but have perhaps come into the markets in recent months hoping for some quick gains. There are many such investors and it's possible that they will lose money. Nothing should be done about this. Such 'investors', retail or not, should not be surprised by their losses.

But there are long-term investors too who are feeling nervous at the volatility in the markets. Here, I think people need to define what is meant by risk and what is meant by loss. Most of us feel cheated whenever the market value of any investment declines. We invest Rs 1 lakh and in just a few months it becomes Rs 2 lakh. Then, when it comes down to Rs 1.6 lakh, we start crying about risk because we've lost Rs 40,000. This is not a loss. Such volatility is part of the same deal that gives us the high returns in the first place.

If you define risk as volatility (which most people do), then the stock markets are indeed very risky. But if you define risk as the probability of suffering a loss over a long-term (which is how I think individual investors should define it), then the risk is entirely manageable and largely dependent on the quality of your investment decisions. So how can you make sure that you make good investment decisions? That's simple--take the mutual fund route and leave it to someone with a public track-record of being a good investor.

Think about it for a moment. When someone gets a serious disease, should they go to a doctor? Or should they declare themselves to be 'retail doctors' and start treating themselves? Just because you have money to invest doesn't mean that you have the skill to invest any more that than having a disease means that you have the skill to cure yourself.

I believe equity investing is a highly specialized task that needs skills and judgement that only a few people have. I'm not saying that this is a skill that only professional fund managers have. There are many individual investors who are good at it and there are many professional fund managers who are lousy. However, it's easy-and dangerous-to convince yourself that you have what it takes to make good investments when the markets are booming.

The daily, hyperventilative tracking of the BSE Sensex in the media creates the impression that the stock markets are a high-risk casino where the one must stake all at unknown odds to stand a chance of making money. And actually, if you are a short-term punter that may well be true. However, for someone who has, over the years, invested steadily in mutual funds with good track records, the markets are an almost sure shot way of getting far better returns than any other investment can provide.

Tuesday, March 23, 2010

SIPs reward only the faithful!!

One of the less foreseeable results of last two years' turmoil on the stock markets has been that many investors are loudly questioning the efficacy of SIPs. One such person I met (a typical case) started off by claiming that SIPs were no good and that he had barely broken even on SIPs in a number of funds over the last four years. This seemed odd because the funds he named had done quite well. I quizzed him further and it turned out that back in 2008, when the markets had crashed, he had immediately stopped all his SIPs. However, he had restarted all the SIPs in August 2009.

Observant readers would have realised that this investor had basically done it to himself. He had invested in a manner that was guaranteed to shield him from any possibility of making money. Unfortunately, this mistake is way too common. The underlying problem is the increasing belief among people who skim the financial media that SIPs are a magical device, akin to the blessings of a god man, and are thus guaranteed to produce profits no matter when. They can stop whenever they feel like and start whenever they feel like and the God of SIPs will protect them.

The basic idea behind SIP, what the Americans would call SIP 101, is that while the general direction of an investment (a fund or even a stock) is upwards, it is not possible to reliably predict the actual fluctuations that it may undergo as part of its general trend.

Instead of trying to time one's investments, one should regularly invest a constant amount. As time goes by and the investment's NAV or market price fluctuates, this will automatically ensure that when the price was low, you ended up purchasing a larger number of shares or units. Eventually, when you want to redeem your investment, all the units are worth the same price. However, because your SIP meant that you bought a larger number of units whenever the price was low; your returns are higher than they would have been otherwise.

That's the way it works. Usually! However, you have to allow it to work by going on investing when the market is low. That's the most important part. At one level, SIPs are nothing more than a psychological trick to make you invest when the market is low. The whole point of investing is to buy low and sell high. If you stop your SIPs when the markets are low and then restart them when they have risen, then you have done the exact opposite of what SIPs are supposed to achieve, and you will get the exact opposite of good returns. Apparently, during the last two years, a lot of people actually did this.

Of course, there are circumstances in which a lump sum investment can (in hindsight) prove to be better. This happens when during a given period; the equity markets keep rising and never fall below the level they were at the beginning of that period. In such a case, a lump sum investment made at the beginning of that period will turn out to have the maximum gains because the buying price was the lowest at that point. The last one year (March 2009 to March 2010) happens to be one such period. However, over any longer period, such cases are rare. Generally, over a long period of time, the ups and downs of the market will ensure that SIP has the better returns.

Thursday, March 18, 2010

Truth about Highest Guarantee NAV policies

Over the last few months, one after another, a number of insurance companies have launched ULIPs which promise to repay the investor on the basis of the highest NAV that the fund has achieved. The pitch is that these funds' NAV effectively does not drop. Once a level is achieved, then the investor is assured of getting at least as much, no matter what happens to the market. It's certainly a very attractive idea. From the way insurance companies are stampeding into launching such products, I'm sure investors must be putting down their money in good numbers-in just a couple of months, six insurance companies have launched such products. Any investor who is told of this concept will immediately start salivating at the thought. Imagine how rich you could have been had you been invested over the last ten years and had been able to lock your investments at the magical value that the markets achieved on the day when the Sensex touched 20,873!

Any investor thinking about this product would say, "What a wonderful idea!" Why don't all investment schemes-whether mutual funds or ULIPs or even portfolio management schemes offer this kind of a protection on all their products anyway. The answer to this obvious question is simple. There is no free lunch. These products don't actually offer what you think they are offering. That is, they do not offer equity returns that never fall.

Instead, they offer an investment system with a very long lock-in (seven to ten years) in which protection is achieved by progressively putting your gains in a fixed income assets which will give returns far more slowly than a pure equity option. The lock-in and the non-equity assets make this a very different kind of investment than the equity-gains-without losses dream that these funds' advertising seems to imply.

However, even that's not the real reason that these funds are useless. The real reason is that if you are willing to lock-in for seven to ten years, then practically any equity mutual fund would deliver this dream of equity-gains-without-losses. Seven years is a very long time. Over such a period practically any equity portfolio into which any kind of thought has gone would capture substantial gains. This is not mere conjecture. Since at least 1997 the minimum total return that the Sensex has generated over its worst seven is 12 per cent, which was over the seven year period from 6th July 1997 to 5th July 2004. The truth is that in a growing economy like India's it's extremely hard to lose money over a long period like seven years. If you are willing to lock in your money for seven years, then for all practical purposes, you have a guarantee of making a profit.

Of course, this is not a guarantee that is signed in a contract and legally enforceable, but it's the kind of guarantee that any thoughtful investor would be willing to believe in. Mind you, this is also not a guarantee that you will get the highest NAV achieved but again, that's the kind of thing that can't be attained if you want the gains of pure equity anyway.

The most instructive thing in this whole business of guaranteed highest NAV products is the contrast between the illusions spun by those peddling complex financial products and the reality of simple, straightforward investing. It just reinforces one's belief that financial products are being designed whose goal is nothing more than to create a marketing hype which can manipulate the psychology of the ordinary saver.