Equity as an asset class #4 – Fallacy of time dependence

Now that we have understood some of the characteristics of stock market returns, we can use that knowledge to understand the importance of time in relation to investing in equity as an asset class. In the last article we saw that with increasing time chances of loss decreases significantly, volatility is lower and returns are likely to be more.

So far so good – where this gets into a problem is that some self-appointed and even genuine experts want to extrapolate this and have you believe in the following:-

1. Equity investments are good only in the long term, preferably more than 15-20 years.
2. If you have a goal which is less than 10 years, you must not look at the equity route for that goal.
3. As you get closer to the goal, get your money into safer avenues such as debt.

Now, all of these are very nice sounding statements which seem quite logical at first glance – unfortunately, these are also not necessarily true. More importantly, following these in a rigid manner will only give you seriously sub-optimal returns which can be injurious to your financial health. Let me try and illustrate it with some data. I have taken values of the Sensex and Nifty between 2002 and 2012 for the observations below.

• Sensex opened at 3262 in 2002 and closed at 18496 in 2012.
• It fell from 21206 to 7697 in the year 2008.
• It also rose from 9720 to 17530 in the year 2009.
• Nifty CAGR return between 2002 and 2012 was 18.9 %.
• Nifty CAGR return between 2002 and 2007 was 39.1 %.
• Nifty CAGR return between 2007 and 2012 was 1.6 %.

From the above and all related data available, it is easy to come to the following conclusion.

While it is true that with increasing time the likelihood of higher returns are more, market returns are essentially non-linear and therefore this is simply not necessarily true. There are periods of 5 years that have given superior returns to the 10 year period etc.

Now the point is how do you know which period will be the most beneficial for your investment? The fact is that you do not and neither does anyone else. We can get a better understanding of the business environment and the markets to make some logical projections but they will often not be right. But that is really not the issue as we do not even need to predict about the market levels. This brings us to the most important aspect of our investments in the markets and it is this.

Unless you sell your investments in equity, all profits and losses in your portfolio are notional and not real. The notional profit or loss may make you feel ecstatic or miserable but does not alter your financial situation at all. It is only when you sell your investments that you realize your profits or losses and that, of course, has a serious bearing on your overall financial situation.

Let me share a personal example with you. While I made my first investments in stocks more than 25 years back, it was only in 2004 that I started putting almost all my surplus money into it. By end of the year 2007, my investments had appreciated 4 times in a span of just 3 years. While it made me feel great, I did not sell it then and therefore the profits were completely notional. Similarly my huge losses in 2008 when my portfolio nearly gave up all the earlier gains were also notional. Today those same investments have grown significantly and enabled me to become financially independent.

So does this prove the point that equity can work only in the long run? Not at all. Had I sold out in 2007 end and used that money to invest further in 2008 I could have reached my state of FI 2-3 years earlier. The point is this – because of the non-linearity of equity returns, it is impossible to predict a relationship between the return and the time frame. Yes with longer time horizons your chances get better but that is about it. Look at Japan, the market has not moved much there for years. Even our markets moved very little between 2007 and 2012. Similarly, even in short periods the markets may give you great returns. Instead of taking a stand  that it is all too complex, we need to understand it better and apply it for us.

Now my assertion is that all of the 3 statements are not factually correct, though they may seem to be true under some conditions. I will explain this more in the next few posts of the series.