"Gentlemen prefer bonds."
- Andrew Mellon (US Businessman, financier, philanthropist, US Treasury Secretary 1921-32. For some readers, Carnegie Mellon University might ring a bell)
It is 'common wisdom' that stocks are better investments than bonds, especially over long periods. After all stocks have earnings that grow over time while bonds only yield interest.
This might be true for single investments made over long periods. Many investors however make investments periodically, like a Systematic Investment Plan (SIP). Of course, SIPs are much advocated by the financial advisers as a prudent tool for market out performance over long periods. I had published 2 posts on this blog showing how SIPs in fact do not generate great returns even over long periods (http://shashankjogi.blogspot.com/2008/06/do-sips-really-work.html and http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html.)
But do SIPs even beat investment in debt? It will depend upon returns from equities and the prevailing interest rates. Looking at history, I tried to compare two SIPs.
-The first was an investment of Rs 10000 in the BSE Sensex on the first trading day of every month.
-The second was an investment of Rs 10000 in a 1 year Fixed Deposit of the leading bank in India every month.
The time period for the study was from January 1991 till December 2008. i.e. a period of 18 years.
Since exact data for fixed deposit interest rates is not available, I took at these as the yield on a 10 year Government of India security plus 1%. (Currently, this yield is around 5.5% while 1 year bank FDs are giving an interest of 8.5-10.5% depending upon the bank. So 1% above G-sec yield is a realistic assumption).
The results were surprising!
(1). BSE Sensex SIP:
A total sum of Rs. 2160000 was invested.
This became Rs. 5575010 (as of 30 Dec 2008)
This implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%
(2). SIP in Bank Fixed Deposit:
A total sum of Rs. 2160000 was invested.
This became Rs. 8076625 (as of 30 Dec 2008)
This implies a return of approximately 12.5% per annum.
The SIP in Bank FD beat the SIP in BSE Sensex!! Over a period close to two decades, SIP investing in debt beat SIP investing in equities!
Many of you might recall the high interest rates in the 1990s. At their peaks, FD rates had gone up to 17% while staying in double digits for the entire 1990s decade.
Post 2002, interest rates softened and fell into single digits. So one would have expected returns from FDs to be significantly lower compared to Sensex since the start the latest bull market in 2003. So how do the two compare?
(1). SIP of Rs 10000 per month into BSE Sensex since Jan 2003 done on the first trading day of the month:
A total sum of Rs. 720000 was invested.
This became Rs. 955836 (as of 30 Dec 2008)
This again implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%
(2). (2). SIP in Bank Fixed Deposit:
A total sum of Rs. 720000 was invested.
This became Rs. 921566 (as of 30 Dec 2008)
This implies a return of approximately 8.3% per annum
Even in a mega bull market, Sensex SIP could not significantly outperform the SIP in Bank FDs! FD SIP investors would have got returns somewhat lower than Sensex SIP but with no volatility and no risk...and would have slept much better than equity investors.
(Note that Bank FD returns are pre-tax figures)
The future is never like the past and conditions always change. Maybe in the future equities significantly outperform debt. Maybe this does not happen. We don't know, though I would tend to lean on the side of equities outperforming debt. But the study made above throws some points:
(1). SIP investing in equity is not necessarily a great tool for wealth building.
(2). Investing into equities is buying parts of businesses. Businesses are subject to competition and also have their ups and downs. Investing makes sense when businesses are available cheap. Investing makes sense when conditions for businesses are favourable. Stock prices reflect future business prospects and when prospects start appearing weak, equity investing loses money. Unless someone seeks mediocre returns, investing should not mean buy-and-hold-till-you-die. If someone wants to practice SIP investing, the same principle should apply. Do not get taken in by glib talk by some talking head in the media
(3). Learn to sell intelligently. It is selling that counts.
Sometimes, everyone should prefer bonds!
Showing posts with label Investing Myths. Show all posts
Showing posts with label Investing Myths. Show all posts
Wednesday, December 31, 2008
Friday, August 15, 2008
Investing Myths - 2
Investing Myths....(Continued from the previous post)
Myth 4:
Asset Allocation is the key to investing success:
A big fat lie!
The investment community loves to push this idea. Allocate your money across various assets. Have a clear plan of how much of your money should go into equities, how much into debt, how much into real estate, how much into gold, etc.
The basic idea behind recommending an asset allocation plan is that when one asset class goes down, some other will go up. Also there would be an automatic rebalancing of portfolio, selling when an asset goes up and buying when it goes down. Buy low, sell high! How nice!
Except that is it far from nice!
Asset allocation is good if two conditions are satisfied:
1.) The assets have no co-relation or are negatively co-related with one another. i.e. the movement in one asset is independant of the movement of the other asset (un-corelated) or if one asset moves up, the other moves down (negatively co-related).
But in real life, stocks and bonds (paper assets) are positively corelated. Gold and stocks might be negatively corelated. Even this relationship breaks down at times. Over the last 5 years, all assets have gone up, stocks, bonds, real estate, commodities, art, etc. Sometimes all assets go up together, sometimes all come down together.
2.) The assets offer more or less, equal return prospects over time. If we assume that bonds will give lower returns than stocks, creating an asset allocation between bonds and stocks will lower overall returns (but also offer lower volatility).
Asset allocation, the way the investment community preaches, lowers portfolio volatility but also lowers returns. I had written a post earlier demonstrating the returns from one particular asset allocation method. The link is: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html
There is no substitute to ability.
Myth 5:
Now that the market is down, it’s especially attractive and you should buy all you can and just hold it.
Being down does not equal attractive. Markets move from extremes of optimism and pessimism. Hence valuations move from seriously overvalued to seriously undervalued on and off. When prices fall, even 30-50%, it does not automatically make stocks attractive. If you are a value investor, you should buy when stocks are cheap, regardless of the extent of rise or fall in a stock.
Again, the investment community loves to give Warren Buffet's example. If Warren Buffett holds on through 50% drops, because then things really are a bargain, then you should do so as well.
In reality, Warren Buffet buys stocks when they are quoting at 50 paise to the rupee. Most of us do not have the capability that he possesses. We get misled by expensive stocks masquerading around as value stocks. We do not have an understanding as deep as Buffet has about most businesses. So we tend to pay Rs 2 for a stock worth Re.1, thinking that we are paying Rs.2 for something worth Rs.4.
How many people bought stocks into the first crash in January 2008? Many did and now they are stuck. We saw a period between 2000 and 2003 when stock prices went down 50%. After each 10% fall, stocks looked better but kept going down. So many highflying stocks on the tech bubble have vanished now.
The bottomline is:
-There is a time to buy and there is a time to sell.
-There is an environment when stocks do well and there is an environment when stocks do poorly.
-Stocks go down for good reasons.
-Understand the reasons, evaluate if there is merit and then buy. Not just because stocks are down.
Myth 6:
Stocks are an excellent hedge against inflation
Yes, but only if...
Have you heard how stocks give returns much higher than inflation, while with Fixed Deposits and bonds, inflation makes real returns tiny? So the Sensex has given an 18% compounded return over the last 29 years while inflation has been 8% on an average. Doesn't it show the power of equity investing in trumping inflation?
But why did stocks not beat inflation in the period 1992-2003? The sensex gave a negative 3% return compounded. Stocks not only lost money in nominal terms, it also lost more money in real terms. Stock market investing over this period impoverished investors, in general.
Stocks do well in a low and stable inflationary and low and stable interest rate environment. Both, high inflation and deflation are bad for stocks. If you recall, the mid to late 1990s was a period of high inflation 8-10% and rising interest rates. The period between 2000-2003 was a period of a global recession and a slowdown in the Indian economy. We then saw a period of low inflation (4-6%) and low interest rates between 2003-2007 which was one reason among many that fuelled the bull market in stocks.
Over the last 30 years, favourable conditions on a general basis ensured that stocks do well. Who is to say how the future will be like? Will it be like the 1970s where inflation was high and interest rates were ratched up? Or will calmer times return. The answer to this question will determine whether stocks are able to beat inflation by a whopping margin. A blanket statement saying that stocks are good against inflation is assuming such good times will remain.
I have merely highlighted a few myths that are commonly held. There are many more. A wise investor will always look for reason and evidence in any such statements before accepting such assertions.
Myth 4:
Asset Allocation is the key to investing success:
A big fat lie!
The investment community loves to push this idea. Allocate your money across various assets. Have a clear plan of how much of your money should go into equities, how much into debt, how much into real estate, how much into gold, etc.
The basic idea behind recommending an asset allocation plan is that when one asset class goes down, some other will go up. Also there would be an automatic rebalancing of portfolio, selling when an asset goes up and buying when it goes down. Buy low, sell high! How nice!
Except that is it far from nice!
Asset allocation is good if two conditions are satisfied:
1.) The assets have no co-relation or are negatively co-related with one another. i.e. the movement in one asset is independant of the movement of the other asset (un-corelated) or if one asset moves up, the other moves down (negatively co-related).
But in real life, stocks and bonds (paper assets) are positively corelated. Gold and stocks might be negatively corelated. Even this relationship breaks down at times. Over the last 5 years, all assets have gone up, stocks, bonds, real estate, commodities, art, etc. Sometimes all assets go up together, sometimes all come down together.
2.) The assets offer more or less, equal return prospects over time. If we assume that bonds will give lower returns than stocks, creating an asset allocation between bonds and stocks will lower overall returns (but also offer lower volatility).
Asset allocation, the way the investment community preaches, lowers portfolio volatility but also lowers returns. I had written a post earlier demonstrating the returns from one particular asset allocation method. The link is: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html
There is no substitute to ability.
Myth 5:
Now that the market is down, it’s especially attractive and you should buy all you can and just hold it.
Being down does not equal attractive. Markets move from extremes of optimism and pessimism. Hence valuations move from seriously overvalued to seriously undervalued on and off. When prices fall, even 30-50%, it does not automatically make stocks attractive. If you are a value investor, you should buy when stocks are cheap, regardless of the extent of rise or fall in a stock.
Again, the investment community loves to give Warren Buffet's example. If Warren Buffett holds on through 50% drops, because then things really are a bargain, then you should do so as well.
In reality, Warren Buffet buys stocks when they are quoting at 50 paise to the rupee. Most of us do not have the capability that he possesses. We get misled by expensive stocks masquerading around as value stocks. We do not have an understanding as deep as Buffet has about most businesses. So we tend to pay Rs 2 for a stock worth Re.1, thinking that we are paying Rs.2 for something worth Rs.4.
How many people bought stocks into the first crash in January 2008? Many did and now they are stuck. We saw a period between 2000 and 2003 when stock prices went down 50%. After each 10% fall, stocks looked better but kept going down. So many highflying stocks on the tech bubble have vanished now.
The bottomline is:
-There is a time to buy and there is a time to sell.
-There is an environment when stocks do well and there is an environment when stocks do poorly.
-Stocks go down for good reasons.
-Understand the reasons, evaluate if there is merit and then buy. Not just because stocks are down.
Myth 6:
Stocks are an excellent hedge against inflation
Yes, but only if...
Have you heard how stocks give returns much higher than inflation, while with Fixed Deposits and bonds, inflation makes real returns tiny? So the Sensex has given an 18% compounded return over the last 29 years while inflation has been 8% on an average. Doesn't it show the power of equity investing in trumping inflation?
But why did stocks not beat inflation in the period 1992-2003? The sensex gave a negative 3% return compounded. Stocks not only lost money in nominal terms, it also lost more money in real terms. Stock market investing over this period impoverished investors, in general.
Stocks do well in a low and stable inflationary and low and stable interest rate environment. Both, high inflation and deflation are bad for stocks. If you recall, the mid to late 1990s was a period of high inflation 8-10% and rising interest rates. The period between 2000-2003 was a period of a global recession and a slowdown in the Indian economy. We then saw a period of low inflation (4-6%) and low interest rates between 2003-2007 which was one reason among many that fuelled the bull market in stocks.
Over the last 30 years, favourable conditions on a general basis ensured that stocks do well. Who is to say how the future will be like? Will it be like the 1970s where inflation was high and interest rates were ratched up? Or will calmer times return. The answer to this question will determine whether stocks are able to beat inflation by a whopping margin. A blanket statement saying that stocks are good against inflation is assuming such good times will remain.
I have merely highlighted a few myths that are commonly held. There are many more. A wise investor will always look for reason and evidence in any such statements before accepting such assertions.
Monday, August 11, 2008
Investing Myths - 1
There are many investing myths that go around as gospels and the ultimate truth in investing. As humans, if someone repeats something sensible sounding repeatedly, for a long enough period, we start believing it to be true. We then do not question its validity and take it for granted. Thats how we are.
Many of these myths are held even by professionals in the investing arena. Some are lies perpetuated knowingly or in ignorance. Some are damn lies, but statistics tell a different story!
I have highlighted a few of them. Take a look:
Myth 1:
You should buy and hold to make money.
Now, how many times have you heard mutual fund managers and other experts stating this? They have 'well chosen' examples to substantiate their claims. Buy and hold stocks for the long run and you will be rich at the end. Afterall, the logic goes, stock markets reflect corporate fundamentals, which in turn are derived from economic fundamentals. For growing economies like India, economic fundamentals in the long run remain positive.
First, how long is this long run? For most people, 10 years is long enough. Over 10 years, stocks always do well.
Or do they?
A quick look at history will reveal different results. There have been many period in the past where stocks have gone nowhere in a 10 year period.
-From 1992 to 2003, the BSE Sensex went down 33% (aggregate not CAGR). Indian GDP grew at close to 6% in real terms during this period.
-The US stock markets have shown many long periods of poor performance inspite of positive economic growth. Between 1964 and 1982, US stock markets gave a 0% return inspite of growing at a 3% real growth rate. Till date, any index investor in the USA would have got no returns for money invested in 1998, a period of 10 years gave no returns.
-The Japanese markets peaked out in 1989 and after nearly 20 years, is still down 60% from those highs.
Experts love to say that stocks should go up because GDP will grow. Not true!
-The Chinese economy is the fastest growing economy in the world, growing at breath taking speeds of 10% or so over many years. Yet its stock market went down 50% from 2001 to 2004. It is down 60% from the peaks hit last year! China might win many gold medals at the Olympics, but its stock market is perhaps the worst performer in the world!
-Someone who had invested in the Indian BSE Sensex in Feb 2000 would have got a compounded return of 10.9% from stocks till date. Not a return to die for. During this period, the Indian economy recorded a 7% real GDP growth.
Let me state this very clearly. Stocks do well in an environment of low and stable inflation and interest rates. Rising inflation and (often hence) rising interest rates are bad for stocks (USA from 1969-1982). A deflationary (falling prices) environment means economic contraction, which is also bad for stocks (Japan from 1989).
Stocks are good for the long run if your starting point is good. If you start off at the begining is a bull supercycle, stocks will give great returns. If you start off at the lower end of valuations, stocks will give good returns. If you are caught in a bear supercycle, stocks will languish.
Stocks are not always a good buy and hold asset class...No asset class is! Each asset class needs a particular environment to do well.
Myth 2:
You cannot time the market.
By this, if someone means catching tops and bottoms precisely by design (and not by accident), I agree. But this is not what market timing is about. By market timing I mean buying when conditions are in your favour and selling when they are against you. Even if you can imprecisely time the markets, in an inperfect manner, your returns will get boosted. I had earlier written a post on this blog showing how one particular market timing strategy achieves superior returns with less risk and lower volatility. (Link: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html)
Market timing is THE essence of successful investing. Traders try to time the markets. Even long term value investors time the market, buying when stocks become cheap and selling when they get expensive. Momentum investors time the market and buy when momentum starts building up and sell when momentum starts fading or reversing.
So do not hide behind the cover of "I dont have time to trade" defense mechanism. You dont need to look at the market every day or every week. Learn how to time the markets, afterall it is your money.
Myth 3:
Making money is all about picking stocks.
Another big myth!
No doubt, stock picking is important. You want to be in a stock that goes up. But merely picking a winning stock is of little significance if you get the other things wrong. You will not make much money.
What are the other things?
Intelligent exits and proper volumes of purchase
Not much fun in picking up Unitech at 100 to see it go to 550 and then back to 130.
You need to sell sufficiently high to benefit from the big price move.
And you need to buy in good volumes on such stocks to make significant money. Your 'position sizing' needs to be correct. Buy too little and you wont make much money. Buy too much and you run the risk of large losses if losses come about.
Look at the portfolios of various mutual funds. 90% of the variance in their performance comes from position sizing, i.e.from their decision on how much to buy. Only 10% comes from superior stock picking.
You don't need to be a great or even a good stock picker to make a lot of money.
Being average is fine as long as you follow a few cardinal rules in investing:
-Trade with the trend. That is where large profits originate.
-Let your profits run but cut your losses short
-Manage risk. Buy enough to make you a bundle, but short of anything that could lose you a lot of money.
Continued.....
Many of these myths are held even by professionals in the investing arena. Some are lies perpetuated knowingly or in ignorance. Some are damn lies, but statistics tell a different story!
I have highlighted a few of them. Take a look:
Myth 1:
You should buy and hold to make money.
Now, how many times have you heard mutual fund managers and other experts stating this? They have 'well chosen' examples to substantiate their claims. Buy and hold stocks for the long run and you will be rich at the end. Afterall, the logic goes, stock markets reflect corporate fundamentals, which in turn are derived from economic fundamentals. For growing economies like India, economic fundamentals in the long run remain positive.
First, how long is this long run? For most people, 10 years is long enough. Over 10 years, stocks always do well.
Or do they?
A quick look at history will reveal different results. There have been many period in the past where stocks have gone nowhere in a 10 year period.
-From 1992 to 2003, the BSE Sensex went down 33% (aggregate not CAGR). Indian GDP grew at close to 6% in real terms during this period.
-The US stock markets have shown many long periods of poor performance inspite of positive economic growth. Between 1964 and 1982, US stock markets gave a 0% return inspite of growing at a 3% real growth rate. Till date, any index investor in the USA would have got no returns for money invested in 1998, a period of 10 years gave no returns.
-The Japanese markets peaked out in 1989 and after nearly 20 years, is still down 60% from those highs.
Experts love to say that stocks should go up because GDP will grow. Not true!
-The Chinese economy is the fastest growing economy in the world, growing at breath taking speeds of 10% or so over many years. Yet its stock market went down 50% from 2001 to 2004. It is down 60% from the peaks hit last year! China might win many gold medals at the Olympics, but its stock market is perhaps the worst performer in the world!
-Someone who had invested in the Indian BSE Sensex in Feb 2000 would have got a compounded return of 10.9% from stocks till date. Not a return to die for. During this period, the Indian economy recorded a 7% real GDP growth.
Let me state this very clearly. Stocks do well in an environment of low and stable inflation and interest rates. Rising inflation and (often hence) rising interest rates are bad for stocks (USA from 1969-1982). A deflationary (falling prices) environment means economic contraction, which is also bad for stocks (Japan from 1989).
Stocks are good for the long run if your starting point is good. If you start off at the begining is a bull supercycle, stocks will give great returns. If you start off at the lower end of valuations, stocks will give good returns. If you are caught in a bear supercycle, stocks will languish.
Stocks are not always a good buy and hold asset class...No asset class is! Each asset class needs a particular environment to do well.
Myth 2:
You cannot time the market.
By this, if someone means catching tops and bottoms precisely by design (and not by accident), I agree. But this is not what market timing is about. By market timing I mean buying when conditions are in your favour and selling when they are against you. Even if you can imprecisely time the markets, in an inperfect manner, your returns will get boosted. I had earlier written a post on this blog showing how one particular market timing strategy achieves superior returns with less risk and lower volatility. (Link: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html)
Market timing is THE essence of successful investing. Traders try to time the markets. Even long term value investors time the market, buying when stocks become cheap and selling when they get expensive. Momentum investors time the market and buy when momentum starts building up and sell when momentum starts fading or reversing.
So do not hide behind the cover of "I dont have time to trade" defense mechanism. You dont need to look at the market every day or every week. Learn how to time the markets, afterall it is your money.
Myth 3:
Making money is all about picking stocks.
Another big myth!
No doubt, stock picking is important. You want to be in a stock that goes up. But merely picking a winning stock is of little significance if you get the other things wrong. You will not make much money.
What are the other things?
Intelligent exits and proper volumes of purchase
Not much fun in picking up Unitech at 100 to see it go to 550 and then back to 130.
You need to sell sufficiently high to benefit from the big price move.
And you need to buy in good volumes on such stocks to make significant money. Your 'position sizing' needs to be correct. Buy too little and you wont make much money. Buy too much and you run the risk of large losses if losses come about.
Look at the portfolios of various mutual funds. 90% of the variance in their performance comes from position sizing, i.e.from their decision on how much to buy. Only 10% comes from superior stock picking.
You don't need to be a great or even a good stock picker to make a lot of money.
Being average is fine as long as you follow a few cardinal rules in investing:
-Trade with the trend. That is where large profits originate.
-Let your profits run but cut your losses short
-Manage risk. Buy enough to make you a bundle, but short of anything that could lose you a lot of money.
Continued.....
Monday, July 21, 2008
Avoid Price Volatility
Some people advise making use of market volatility. Market go up and they go down. So according to this view, one should profit from market volatility, i.e. buy when prices go down and sell when prices go up. Of course, this is the classic 'buy low sell high' approach. Nice in theory, but not so easy to practise. After all no one really knows how low is low and how high is high, and for how long the low and high states will remain.
Then there are others who suggest that since volatility is a part of the market, one should accept volatility and expect markets to give good returns over a longer run. This view suggests that one assumes market volatility as given and ignore the period to period fluctuations in prices with an eye on the longer term end result.
However, market volatilty is not good for your portfolio.
Take an example as follows. There are two portfolios. Portfolio A is quite volatile with returns swinging between positive and negative. Portfolio B is very stable, returning the same 14% return year after year.
Lets assume that portfolio A has the following returns over a 10 year period:
50%, -20%, 65%, -30%, 40%, -15%, 100%, -45%, 70%, -35%
The average of all the above 10 figures is 18% per annum. One could be tempted to think that over a 10 year period, one would get a 18% return on the initial capital. That is unfortunately not true. A rupee invested at the begining of year 1 would become 2.004 after 10 years. This implies a return of only 7.2% per annum compounded (You can do your own calculations).
Because the returns were volatile, the compounded returns were less than half of that of the arithmetic mean. Volatility causes returns to diminish!
Instead if you assume that portfolio B gives a steady return of 14% per annum, a rupee invested in portfolio B at the begining of year 1 becomes 3.70 after 10 years.
Even though portfolio B has a lower arithmetic mean (14% per annum) than portfolio A (18% per annum), it still gives a higher compounded return than portfolio A.
A quick look at the BSE sensex from 31 March 1979 to 31 March 2008 paints a similar picture. The arithmetic mean of yearly returns comes out to be 27.6% per annum. However, the compounded returns are 19% per annum.
The implications of this need to be noted.
First, we tend to dislike volatility on a psychological level. We generally dont like our portfolios to keep swinging wildly. We feel uncomfortable and anxious when volatility kicks in. But on a returns plane as well, volatility (or more correctly, downside volatility) tends to reduce returns regardless of the order in which the volatility occurs. (A positive 20% and a negative 20% leads to a negative 4% absolute regardless of the order in which returns come in). So when markets become volatile, we are well advised to trade less or not at all.
Secondly, if you are a long term investor, you will benefit even more by minimizing volatility in your portfolio. Considering the sensex example above, at 27.6% since 1979, the sensex would have been at 117400 and not 15644 as of March 31 2008! This is a multiple of close to 7.5. i.e. by avoiding volatility you could have been more than 7.5 times richer than by accepting volatility.
It is a common belief that if you know what to buy and buy it at the right time, the money taps would be opened for you. I have maintained my stance that what to buy and when to buy and not as important as it is made out to be. There are many other hidden factors (like avoiding volatility) that are quite neglected from our investing plans. It may not be a bad idea to consider means of avoiding portfolio volatility.
Then there are others who suggest that since volatility is a part of the market, one should accept volatility and expect markets to give good returns over a longer run. This view suggests that one assumes market volatility as given and ignore the period to period fluctuations in prices with an eye on the longer term end result.
However, market volatilty is not good for your portfolio.
Take an example as follows. There are two portfolios. Portfolio A is quite volatile with returns swinging between positive and negative. Portfolio B is very stable, returning the same 14% return year after year.
Lets assume that portfolio A has the following returns over a 10 year period:
50%, -20%, 65%, -30%, 40%, -15%, 100%, -45%, 70%, -35%
The average of all the above 10 figures is 18% per annum. One could be tempted to think that over a 10 year period, one would get a 18% return on the initial capital. That is unfortunately not true. A rupee invested at the begining of year 1 would become 2.004 after 10 years. This implies a return of only 7.2% per annum compounded (You can do your own calculations).
Because the returns were volatile, the compounded returns were less than half of that of the arithmetic mean. Volatility causes returns to diminish!
Instead if you assume that portfolio B gives a steady return of 14% per annum, a rupee invested in portfolio B at the begining of year 1 becomes 3.70 after 10 years.
Even though portfolio B has a lower arithmetic mean (14% per annum) than portfolio A (18% per annum), it still gives a higher compounded return than portfolio A.
A quick look at the BSE sensex from 31 March 1979 to 31 March 2008 paints a similar picture. The arithmetic mean of yearly returns comes out to be 27.6% per annum. However, the compounded returns are 19% per annum.
The implications of this need to be noted.
First, we tend to dislike volatility on a psychological level. We generally dont like our portfolios to keep swinging wildly. We feel uncomfortable and anxious when volatility kicks in. But on a returns plane as well, volatility (or more correctly, downside volatility) tends to reduce returns regardless of the order in which the volatility occurs. (A positive 20% and a negative 20% leads to a negative 4% absolute regardless of the order in which returns come in). So when markets become volatile, we are well advised to trade less or not at all.
Secondly, if you are a long term investor, you will benefit even more by minimizing volatility in your portfolio. Considering the sensex example above, at 27.6% since 1979, the sensex would have been at 117400 and not 15644 as of March 31 2008! This is a multiple of close to 7.5. i.e. by avoiding volatility you could have been more than 7.5 times richer than by accepting volatility.
It is a common belief that if you know what to buy and buy it at the right time, the money taps would be opened for you. I have maintained my stance that what to buy and when to buy and not as important as it is made out to be. There are many other hidden factors (like avoiding volatility) that are quite neglected from our investing plans. It may not be a bad idea to consider means of avoiding portfolio volatility.
Sunday, July 6, 2008
Comparing 5 Investing Strategies
"Don't try to time the markets".
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".
The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.
Do such statements really hold weight? An examination is worth the time spent.
But first, let us figure out what constitutes a good investment.
The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.
However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.
Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.
Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.
The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.
(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)
With this little background, let us compare 5 different investing strategies.
All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:
1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.
2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?
3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.
4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).
5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.
So how do these strategies compare? Given below is a table depicting their performance:
(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)
Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).
Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.
Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:
A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.
Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.
Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".
The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.
Do such statements really hold weight? An examination is worth the time spent.
But first, let us figure out what constitutes a good investment.
The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.
However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.
Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.
Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.
The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.
(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)
With this little background, let us compare 5 different investing strategies.
All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:
1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.
2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?
3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.
4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).
5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.
So how do these strategies compare? Given below is a table depicting their performance:
(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).
PE based Asset Allocation also gives a better performance compared to the other three. Buy and Hold strategy gives a higher return than an SIP or price based asset allocation, but has the largest drawdown.
Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!
Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!
Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.
Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:
A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.
Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.
Sunday, June 29, 2008
Do SIPs really work?
A Systematic Investment Plan (SIP) is an investment plan that allocates a fixed sum of money (usually the same amount) at a regular frequency (month/quarter/etc) to an asset class (like stocks/bonds/gold/etc). For example, every month you invest, say, Rs. 25000 in a mutual fund and keep doing this month after month.
SIP is an idea that the professional investment community loves to push. Every day we read so called experts advising people to go in for SIPs. Mutual funds come out with advertisements urging investors to buy a SIP in their companies. It is common wisdom that SIP is a good way to make money over the long term.
SIPs look like a great idea. It is convinient and affordable for the average investor. All you have to do is to simply put away a small sum into the markets - the same amount every month. When prices are low, you get a higher number of shares or mutual fund units. When prices are high, you get a smaller number of shares/units. A classic case of rupee cost averaging, which essentially is the foundation of a SIP! It seems like a great way to take market exposure and a great way to make money.
There is just one little thing. It doesn't work!!
Have a look at empirical evidence. If you had invested Rs. 10000 in the BSE Sensex on the first trading day of every month from January 1992 till April 2003 (more than 11 years) your total investment of Rs. 13.6 lakhs would have become 12.33 lakhs giving you a -1.8% return compounded annually over the period. You would have actually lost money. Compare this with a one-time investment in the Sensex in January 1992, which would have given you a 4% (positive) annual return. Add transaction costs and the performance of the SIP would look worse.
How about the period in the current bull run? From May 2003 till date (27 June 2008), the Sensex has gone up at the rate of 34.6% compounded annually. In contrast, the same SIP would have invested Rs. 6.2 lakhs and would have made Rs. 11.17 lakhs at an annual compounded growth rate of 23.7%. Not bad, but still lower than the return on a lump sum investment!
One instance where rupee cost averaging (and hence a SIP) can work in the long run is, if for the first 7-8 years prices keep falling and take off steeply in the latter part of the investing period.
Rupee cost averaging - like diversification- does not make you more money. It prevents you from losing more money in certain market conditions (like a falling market) than you would have lost otherwise. If that's good enough for you, fine. But if you are convinced that a market or asset will go up over time, rupee cost averaging does not make sense. In short, if you like an investment, simply go for it.
SIP is an idea that the professional investment community loves to push. Every day we read so called experts advising people to go in for SIPs. Mutual funds come out with advertisements urging investors to buy a SIP in their companies. It is common wisdom that SIP is a good way to make money over the long term.
SIPs look like a great idea. It is convinient and affordable for the average investor. All you have to do is to simply put away a small sum into the markets - the same amount every month. When prices are low, you get a higher number of shares or mutual fund units. When prices are high, you get a smaller number of shares/units. A classic case of rupee cost averaging, which essentially is the foundation of a SIP! It seems like a great way to take market exposure and a great way to make money.
There is just one little thing. It doesn't work!!
Have a look at empirical evidence. If you had invested Rs. 10000 in the BSE Sensex on the first trading day of every month from January 1992 till April 2003 (more than 11 years) your total investment of Rs. 13.6 lakhs would have become 12.33 lakhs giving you a -1.8% return compounded annually over the period. You would have actually lost money. Compare this with a one-time investment in the Sensex in January 1992, which would have given you a 4% (positive) annual return. Add transaction costs and the performance of the SIP would look worse.
How about the period in the current bull run? From May 2003 till date (27 June 2008), the Sensex has gone up at the rate of 34.6% compounded annually. In contrast, the same SIP would have invested Rs. 6.2 lakhs and would have made Rs. 11.17 lakhs at an annual compounded growth rate of 23.7%. Not bad, but still lower than the return on a lump sum investment!
One instance where rupee cost averaging (and hence a SIP) can work in the long run is, if for the first 7-8 years prices keep falling and take off steeply in the latter part of the investing period.
Rupee cost averaging - like diversification- does not make you more money. It prevents you from losing more money in certain market conditions (like a falling market) than you would have lost otherwise. If that's good enough for you, fine. But if you are convinced that a market or asset will go up over time, rupee cost averaging does not make sense. In short, if you like an investment, simply go for it.
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