4 Key Investment Questions

This article was originally published in Market Express

“One of my friends suggested that I invest in Asian Paints now since the market expectation is that it is likely to announce good results, and historically it has done so well. However, he told me that if I have to make money in the stock market, I should be invested for the long-term”

Such conversations can sound very familiar and we may even act on the advice since it sounds very logical. But here are the problems with that statement:

  1. There is an advice to time our investment (market timing)

  2. There is an advice to invest in a stock because it has done well in the past (past performance)

  3. There is an advice to invest for long-term without defining what is long-term, and finally

  4. There is an advice from a friend, who may or may not be an investment advisor or specialist.

Question 1: Should we wait for good time to invest in market?

There is no good or bad time to invest, just like there is no good or bad time to look for a job! Even if there is one, it is known only after the fact and hence it is useless. Let us flip this question and ask “How can I time the market correctly?” This question, in other words, means that we should be smart enough to buy at the bottom and sell at the top and therefore make money. However, the bottom or the top is evident only, after the fact and not before. For e.g., if you look at a historical chart, you can know what is bottom or top, but if you are asked to draw a graph into the future clearly identifying the bottom and top, I am sure only 0% of the people can do it. If you have to get the market timing right, you should be right two times (predicting the top and predicting the bottom). You should be right two times, every time you make an investment call. Nearly impossible, from a probability point of view. Hence, the best answer is there is no good or bad time to invest in the market. So long as you have a consistent investment habit, over a period, timing will be irrelevant. As they rightly said, “time in the market” is more important than “market timing”.

Market timing will hurt you if you have sporadic investment habits as you may be caught in a bad cycle and will have to wait forever to recover your losses. Alternatively, you may be lucky enough to have a great start and can see through several bad years since the start was good. For e.g., if you invested at the beginning of 2008 in the Indian market, your investment value would be down by 52% at the end of 2008 and you will be still licking your wounds till 2013 which is when you would have broken even. On the other hand, if you invested at the beginning of 2009, your investment value would be up by 76% at the end of 2009 itself, and another 44% in 2010 and you will be laughing your way until now. Nevertheless, both outcomes are unpredictable and is purely a factor of luck. Hence, the idea of timing the market is a bad one. Instead, one should have a consistent way of investing in the market.

Question 2: Should we invest based on past performance?

The now familiar mutual fund disclaimer “past performance does not guarantee future returns” played in double-quick speed in television ads is really a good disclaimer to focus on. However, in the absence of another alternative, the question becomes, “what else to look at?”

Whether, we want to invest in a mutual fund or individual stocks, we always get obsessed with how they have done. Here again, there are two problems. One pertains to doing well and the other pertains to doing well consistently. The second aspect is more important than the first aspect. It is possible that a mutual fund or a stock can perform better than others can, but they cannot do it consistently year after year. In other words, they may be winners today with no guarantee that they will be winners tomorrow. The challenge for us is to identify tomorrow’s winners not yesterday’s winners. Many investors base their investment decision on fund ratings (remember the Morningstar or Value Research stars ratings from 5 star to 1 star). However, research has shown that 5-styar funds need not do well going forward nor 1-star funds need to do badly.

The issue of examining past performance is again linked to market timing and hence can be an ineffective tool for investment decision. Again, a consistent investment plan will obviate the need to depend mainly on past performance.

Question 3: What is Long-term?

A typical gut based answer will be 3-5 years. However, this number is not backed by any research. A long-term is simply that period where even if you are caught with a wrong start (like 2008), you will have enough time to recover your capital and move on. It can be 3 years, 5 years or even more depending on the market that you are looking at. Here, the concept of “drawdown” can be helpful to frame an answer. According to Investopedia, “A drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high” For eg., if the value of investment is 100 to start with, and then it goes to 70 in the next three years and climbs back to 100 in another two years, then the full drawdown cycle is 5 years. In other words, you waited for 5 years just to get your money back. Let us look at this for the Indian stock market in the last 20 years. (Nifty)

In the last twenty years, Nifty experienced six major drawdowns. Drawdown 4 is the longest and most testing drawdown lasting 72 months. In other words, if you had invested on 31st December 2007, you would have to wait 72 months before recovering your investment. Drawdown 5 was the smallest 6 months. The longest drawdown of 72 months or 6 years can then be considered as a reasonable proxy for defining the long-term. However, this is not to suggest that in future drawdown duration will always be less than 72 months. If and when a new drawdown occurs with more than 72 months, we should be willing to revise our definition of long-term accordingly, But for now, suffice to say that 6 years is reasonably a good definition of a long-term.

Question No 4: Who to approach and ask if I have a question regarding my investments or savings or retirement planning?

This may look to be a trivial question, but need not be so. Where do we source our information and knowledge is a key aspect to finding the correct solution. Many a times, sourcing information or knowledge happens adhoc mainly through friends, office colleagues and relatives. However, these can be sub optimal. Investing some time to identify the correct person/institution to seek advice from is extremely crucial. In the context of investments, an independent financial advisor can fill this vacuum, even if you are a financial expert yourself. Just like knowing which doctor to go to if you have a disease diagnosed, it is also important to have a trustable independent financial advisor to manage your money and advice you on many things including retirement planning, real estate, insurance, etc.

Trust and independence are essential characteristics to choose a financial advisor. He/she should have proper accreditation, experience and poise to understand your specific situation and provide advice accordingly. Independent advisors do not seek compensation from the product providers and seek compensation only from clients for whom they provide the advice. (fee only advisors) This establishes the fact that the advisor will only work in your interest and not in the interest of the organization whose products he/she is recommending as part of your portfolio. Imagine a doctor telling you that he will not charge you any fees because he gets commission from pharmaceutical companies for prescribing their drugs! A transparent advisor can help build the needed trust and this will create a win-win situation. How to spot such an advisor? That is a difficult thing. You may have to use your existing network (family, friends, relatives, colleagues) to get references or you should be prepared to do your own research on the internet and reach out to them proactively. Many investors may think that they may be too small for an advisor to commit his time. This may not be true as there are many mid-sized boutique advisors who specialize only in serving mid-sized clients.

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