Equities and the long-term approach

The reversal after May 10, 2006 has caught many investors unawares. Day traders had to cut their positions at a loss. Arbitrageurs got stuck with open positions after suspension of markets.

Brokers' terminals were switched off by stock exchanges and a major sell-off was initiated to cover-up their shortfalls. Collaterals with banks for "loan against shares" hit triggers for sell-off. And all this happened in a matter of 20 days.

Most of us tend to get information about the 'fundamentally' good stocks, which may show hefty returns within a few days or months of holdings. Investors made money during the three months prior to the May crash.

While the past is full of examples of hefty returns in a short time frame, why do most equity analysts and experts keep touting the long-term approach?

'Long-term investors' have lost 30 per cent of their investment value within 19-20 working days, so why do equity experts keep emphasising the long-term approach?  When most of us need absolute return, why do analysts and risk management specialists keep talking about "risk-adjusted return"?

Defining 'long-term'

The core of the issue relates to the interpretation of 'long-term'. Does long-term mean one, two or five years? Does it make sense to look beyond five years ignoring intervening scenario?

Long-term relates to an approach, which talks about returns on a cumulative basis and in totality. It may not mean a time horizon. Look at the productive years of your life. Do you wish to earn for three years and lose a substantial part of it in the fourth year?

In fact, what you want is an assurance that on a cumulative basis or in totality, over the next four years, you get the best possible.

Time value of money

Assume a day trader, who trades for 150 days in a year. He may make handsome money on a few days and may lose out on a few other days.

However, he may not be aware whether his cumulative earning over 150 days yielded him a superior return in percentage terms over money invested.

Normally, most of the retail participants cannot work out a return in percentage terms. This is because of their inability to consider time value of money in additional investments and withdrawals at different points of time.

Long-term approach

Small investors and traders are misguided due to incorrect interpretation of long-term investing. They often work out wrong figures of cumulative earnings ignoring time value of money. This puts them in a situation where they may be trapped by their own timing decisions.

A long-term approach means that we should look into the totality of returns coming from various ventures and trades. Over the long-term, equities tend to outperform other markets. This really means that it happens on 'totality or a cumulative basis'.

Cumulative returns need to be considered over periods of good as well poor returns. We need to have an approach of cumulative returns over various short periods. It may be 10 years and above for many of us, may be five years or may be even one year for regular day-traders.

Period of holding stocks

The extent of accumulation is the real test to determine what long-term is. Assume person A had an exposure of Rs 60 lakh (Rs 6 million) in equities on May 10, 2006.

With a crash of 30 per cent, it would result in a erosion of wealth to the tune of Rs 18 lakh (Rs 1.8 million). However, he tends to forget that earlier, he made Rs 60 lakh (Rs 6 million) from just Rs 18 lakh (Rs 1.8 million) of capital invested two years ago.

Over time, this smaller capital base grew to Rs 60 lakh (Rs 6 million).  (It is irrelevant here how he got it done - whether by day trading or short-term trading or by long-term investment).

After this market crash, the right approach is to look at the appreciation from Rs 18 lakh to Rs 42 lakh (Rs 4.2 million). This is the cumulative effect of various short-term ventures and periods and the essence of investing in the long-term.

Let's understand the concept of totality, which is the second dimension of long-term investing. In the example of A, while there was a setback of Rs 18 lakh in one month, other investments in properties, bonds, commodities and the most important - in his own highly profitable aluminum business also needs to be taken into consideration.

Adding all these other investment values, he can count the total wealth at Rs 1.50 crore (Rs 150 million) in which equity exposure is just 40 per cent. Without a totality view, a prudent asset allocation among debt, equity, commodity and property cannot be done.

The third dimension of long-term approach is in understanding the dynamics of economy and 'long-term short position' towards it.

For example, we need to buy necessities. Buying commodities and articles for meeting expenses means you are squaring off your naturally existing short position.

As short positions keep coming up throughout your life, a long position for investments over the longer periods will act as a natural hedge.

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