A potential investor faces a barrage of questions before the investment advisor gives an opinion. Typically one is asked, 'what is your investment horizon?' And most often, the investor would suggest some time horizon like one year or three years. The investment plan is then built around such inputs.
However, when the investor is asked what he or she proposes to do with the proceeds after the suggested time period, the answer in almost all cases is quite revealing. Most often the investor intends to reinvest the money.
If that is the case, what actually is the investment horizon for the investor and what is it with respect to the specific investment avenue being considered?
Many a time, if one thinks from one's own point of view, the actual time for which the money would be invested could be quite long, may be 20 to 25 years. However, when one looks at the investment option, the investment horizon shrinks. Why does that happen?
One possibility could be the lack of faith -- either in the investment option or the investment manager or the advisor who recommends the product. The other possibility could be the anxiety created by the gyrations of the stock markets.
Faith in anything uncertain and specifically in the world of investments is a function of knowledge regarding the basic dynamics of the situation and the factors that can affect the eventuality.
As quoted by the investment guru Benjamin Graham, stock markets are like voting machines in the short term, but are like weighing machines in the long-term.
This relationship is very important to understand since the short-term movements of stock prices are governed by the mood of the market, viz, the players in the market at that point in time.
However, if the underlying companies perform in a particular manner, the stock prices eventually follow. The confusion arises since the relation between performance of the economy or the companies within the economy and the stock prices is not linear, which distorts the picture in the short run.
Let us see what we mean by the relation between the performance of the economy/companies and the stock prices.
Assume someone invested in the Sensex after it went up by 100% for the year. (This is just an example to make a point and investment in Sensex for longer periods was not possible until the arrival of Index Funds). Can someone expect to make money after that? Well, the year was 1985 when the Sensex more than doubled in the calendar year 1985.
However, the value of Sensex was below 600 points. If someone held on to the investment for the next twenty years, one would have multiplied one's money by over 20 times, or an investment of Rs 10,000 would be worth Rs 2 lakh (Rs 200,000).
Even if one considers a low point before the current rally began, the Sensex was around 3,000 points in May-2003, which means the value multiplied five times in 18 years, which is equivalent to around 9.5 per cent p.a. compounded annually. Incidentally, this example also explains the non-linearity of the price movements.
Why did the investment grow in such a fashion? For that one need not go to experts for their detailed analysis. Look around us and we find the answers. In 1985, a car was considered a luxury for most of the middle class, today it has become a necessity.
Having one phone in the family was uncommon in those days. Today, many of us have more than one phone per person. It is just that the economy has grown by leaps and bounds and the stock prices have followed.
If this understanding is clear, one can be comfortable throughout the ups and downs of the stock market since one knows that these are going to be temporary.
Let us look at another example, which is outside of the world of investing.
When one wishes to travel from one place to another, what is the information shared with the booking agent? Say, one is travelling from Mumbai to Delhi by train. Will one go and tell the travel agent that one wants to travel from Mumbai and Baroda? What will the traveller do at Baroda?
Get down from the train, assess the information whether the train journey was in line with one's expectations or not and then decide the further journey plan -- whether to take a train or a bus or a flight.
This looks to simplistic as an example, but the difference between this example and investment in stock markets is about the knowledge and information. While one prepares the journey plan, one can comfortably assume certain things about the overall journey at the time of taking a decision.
It is important that one keeps the total investment horizon in mind while making the plans. Of course, monitoring of the portfolio is very important and one may need to do the necessary course correction along the way.
The investor has many options with ease of assessment and easy liquidity that allow better monitoring. In today's world, information about various options is also available more easily than in the past. And that is exactly why understanding the dynamics of investment is critical before one signs the cheque.
The writer works with a leading mutual fund and the views expressed are his personal views.
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