A Lesson from the River

On a recent trip to Rishikesh, I got to spend time on the banks of Ganga. The ambience with relaxing sound of flowing water and beautiful sight of the clouds in the sky was so magnificent that it is difficult to describe the experience.

ये किस कवि की कल्पना का चमत्कार है,
ये कौन चित्रकार है?

As I stood there observing people around, the mind started wandering and suddenly I felt that the river holds a great lesson for those interested in stock markets (aka share market). What has the beautiful river got to do with stock market investments? Read on.

People exhibit three different behaviors when faced with the flowing water of such a big river.

1. Champions
Some people swim in the river exercising different strokes and going from one bank to other with ease. They are good swimmers, and do not have any fear of drowning even when they are in deep waters. These people seem to derive maximum pleasure from their time in the river.

2. Adventurous
Some people engage in swimming or rafting in the river even if they do not know swimming that well. Given the risks involved, their experience of the river may turn out to be scary for them as well as for the onlookers.

3. Conservative
Most people are scared of the deep river and they just sit near the bank dipping their feet in the water. If the have to cross the river, they use the bridge. The conservatives do not get to experience the real river from close quarters.

हौ बौरी डूबन डरा, रहा किनारे बैठ

In some way, stock market resembles this river. Stocks are commonly perceived as a high gain high risk investment with a strong belief that only if you are good and lucky, you can make money on it else there is a serious risk of losing. You can easily spot similar behaviors around stock market as well. You can find expert players who play the right moves in the market and derive maximum gain out of it. Then there are those who try their luck in stock trading without adequate knowledge and usually get bitten in the process. Have we not heard stories of people who jumped into stock trading and lost money or even got bankrupt when the market sprung a surprise? That's why most of us are too scared of stock market and stay away from putting our hard earned money in shares. As a result, we stay out of the river and fail to take advantage of the growth potential offered by stocks.

Is there a way to experience this river more closely without undue risk of drowning? Oh yes. When we took a boat ride with twenty fellow passengers to cross the river, it gave us a closer feel of the river in a safe manner. Let us find the equivalent of a safe boat ride for stock markets.

Advance warning - reading beyond this point may change your outlook about stock market forever. Please proceed at your own risk. I am not an expert, so do not expect any hot tips from me - my attempt is to look at our attitude towards the market. If you are scared of stocks, this post is going to take this fear out of your mind and demonstrate how you can reap the benefits in a relatively safe manner by riding the boat of mutual funds and systematic investment plans. I am going to list a few common fears and dispel them – and my arguments are going to be based on hard data.
 
Fear 1. Stock market do not have predictable returns. I am saving money for my old age and I cannot gamble with these funds.

The fear seems very real. Look at this chart that shows BSE Sensex movements in last 24 years. There are scary ups and downs scattered around in the chart in a completely unpredictable manner. For example, around October 2007 it rose to 20000, and then crashed to 10000 in next 12 months. Who would invest in such an unpredictable instrument?
Let us try a paradigm shift now. Look again at the chart carefully, and you can spot a steady upwards trend. The chart also shows trend lines of 6-15% returns per year. Sensex has grown at an average rate of 15% per year during this period. It is difficult to get this kind of tax-free return anywhere else. So, if you are saving money for your retirement, stocks offers you the best returns.


Here are some specific numbers. Imagine you save Rs 1000 in 1991. If you park this money in an FD with an 8% return, it grows to Rs 6000 in 2014. Even an investment with a 12% return would yield only Rs 15000, while the same amount put in Sensex would grow to Rs 30000. Is it not the best option for your retirement saving?




Fear 2 – Average returns are fine, but what if I exit the market at wrong time causing a loss?

Right now it looks good as market is at a high, but the returns will be lower if you exit when it is lower. Look at the first chart again and it shows that the worst case is to exit in 2003 and it still gives you a return of 10%. The chart on the right shows what happens if you invest Rs 1000 in Sensex in 1991 for varying periods less than 24 years. After four years, you will have Rs 3700, after eight years Rs 3300, and so on. If we compute the rate of return on the investment, it will be in the range of 10% to 39%. So, the data seems to indicate that even in the worst case scenario, you get a return of 10% per year.









Fear 3 – The market is at a high right now. The window of opportunity is already gone. I will lose money if I enter now.  

It sounds logical that if you enter the market when it is at a peak before a crash, and exit just after the crash, you will lose money. But you can reduce the risk by holding your investment for a longer period. For example, even if you invested at the peak in October 2007 and held on to your investment, your Rs 20000 would have grown to Rs 29000 in 7 years.

Let us develop a method to analyze these different scenarios. The table here shows how you can compute the rate of return on investment done at a specific time. For example, the first row says that if Rs 1 lakh is invested in Sensex in Jan 2001, it will buy 23 units at Rs 4327 each, and if it is sold 5 years later when Sensex is at 9920, it will fetch Rs 229270. This amounts to total return of 129% for the five year period, equivalent to 18% compounded every year.

Using this method, you can compute the ROI for any start date and duration. I did this exercise to find the ROI for an investment done for one year in Sensex with all possible entry times during 2000 to 2010. Then I repeated the calculations for 2,3,4, and 5 years duration of investment. The table on the right summarizes the results.

This says that for a one year investment the ROI varies from 96% to -53%, so you have an equal  chance of making money and losing money. If you invest for two years, the ROI varies between 59% to -20%, so the risk of loss gets reduced. With an investment period of 5 years, the ROI changes to 46% to -1%. This is clear evidence that If you invest for longer term, there is little risk of losing money. This is a key characteristic of stock investments. Hence you should put your money in the market if your investment horizon is 5 years or more. The charts here also stress this point.

Fear 4 – I do not know how to time the market correctly

You can not time the market; It should be possible to invest any time and reap the benefit. As seen earlier, a long term investment will earn a good return in most situations. However, there are times when you may end up with a small or negative return on it. As this table shows, A 1 Lakh invested in Sensex in October 2007 will have a value of Rs 93283 after 5 years, ending up in a loss of 7%. If you defer the investment by a few months to March 2008, it will have a value of 120399 with a 20% gain. So, timing still has an important impact.
  
The best way remove this timing dependency is  by periodic investments, also named SIP (systematic investment plan) in which you put in a small amount every month.Instead of a lump-sum amount, consider investing this amount in 12 monthly installments. After 5 years its value will be Rs 119176 with a gain of 19%. So use SIP with a long term investment and you do not need to time your investments any longer.

Fear 5 – I am neither knowledgeable enough nor have the time to manage a stock portfolio

You do not need to know swimming to take a boat ride. Similarly there is no need of deep knowledge of stock market if you use equity mutual funds. These funds keep a portfolio of good stocks and are actively managed by experts, so you are saved the trouble of portfolio management. In the extreme case, you can just buy units of an Index fund from a reputed mutual fund house and it will give you a return equal to Sensex. If you want to compare the performance of different mutual funds - there are many good web portals that provide this information. https://www.valueresearchonline.com is a very useful reference.

So just remember this simple formula with three basic rules
A.    Think long term. Invest for at least 5 years.
B.    Use regular SIP investment to get into the market
C.    Use the mutual funds route 

Just decide an amount you can save every month and buy the chosen MF units with it. That’s all you need to do. As an example, imagine you put Rs 5000 per month in an index fund for 15 years starting 2000. After 15 years, your fund will grow to Rs 32 lakhs – giving you a 15% return.

You can also use this information of expected returns to plan for your financial goals. Assume you want Rs 10 lakhs to meet some needs 8 years from now. With a 15% return, you can estimate that a Rs 5000 SIP every month is adequate to meet this goal. If you started in 2000, you will find after 6 years that your funds have reached the target goal. At this point you may choose to exit the market and realize your goal earlier, or park the money in a debt fund.

Let us examine the worst case now. The next chart shows what happens if you start a SIP when the market was at a peak in 2007. Even in this worst case scenario, a SIP yields a return between 13% to 15%.


Fear 7 – My savings are not significant for putting into stocks 

No amount is too small for investments. Using Mutual Funds, you can start really small and there is no need to have a large fund upfront.

This discussion still may sound contrary to how you feel about stock market. The real paradigm shift is the move from speculation to investment. When you play for short term gains in the market, you are speculating on the market fluctuations. Since there is no money generated in the market, speculation is a zero sum game where you win at the expense of someone else who loses. This is inherently risky and unpredictable. On the other hand, when you play for the long term, you are investing in business that gives you a reasonable return in long term. Businesses create value over time that generates the returns, and hence it is a win-win for all. A risk is that the business may go down, and the safety measure for that is to use a diversified portfolio. In fact all mutual funds employ the technique of diversification.   

I hope reading this post helps you get started with Mutual Funds. Remember to start with small steps using SIP and do not try to jump onto the bandwagon in one go. Have a portfolio of different kind of investments and remember not to put all your money in stocks. If you have no equity exposure, a good target is to have 30% of your money invested in equity mutual funds.