Almost everyone espouses the virtues of long term investing. The voice grows louder when the markets are crashing. You would have heard many examples of great companies go up a few hundred times in 10-20 years but how many investors are able to ride the entire upswing. Very few, I am sure. This is not it. A few companies that got beaten down in during the last bear market have turned out to be multi-baggers since the crash. In hindsight, it is easier to say that the stock was available at dirt cheap prices and was a no-brainer. Again, how many bought and waited for such stocks to do so well? It is easier to sit on the sidelines and comment what could and should have been done. An investor goes through myriad of emotions when the markets are volatile and not every decision he/she makes can be expected to be rational.
You need to delve deep into investor psyche to understand what makes long term investing difficult? I will discuss some of the aspects that make it difficult for the investors to stick to long term investing. I will not focus on the product selection but only on the behavioural aspects.
You need the ability. Just attitude will not do
If you have to dip into your long term investments every time you have an emergency, it becomes difficult to be a long term investor. The basic premise of long term investing is that only that money goes towards long term investments that you are not going to need for the long term. In absence of this premise, your attitude towards risk is irrelevant. You may have an excellent understanding of company financials and fundamentals and have the mental fortitude to ride out the volatility that is associated with the equity investments. However, it is immaterial if financials require you to dip into the long term savings in case of every emergency. Your financials won’t allow you to be a long term investor in such a case.
You sell winners and keep losers
No one likes to sell at a loss. Additionally, people do not want to make lesser gains than they are already making. The result: You keep the losers for the long terms and sell winners at a small profit. You will sell at 20% profit and hold even at 40% loss. In fact, a lot of people become long term investors because they don’t want to sell at a loss.
I am not saying that such companies cannot turn around or the price cannot bounce back. However, the price will bounce back on the strength of company fundamentals and not because you choose to hold the stock for the long term. So, you need to check on regular basis if the fundamentals are in place. If things are off, you must exit.
One of the reasons for not selling losers is that nobody wants to acknowledge mistakes. Well, everybody makes mistakes and there is nothing to be ashamed of. This brings us to my next point.
Everyone keeps harping about how Nifty (or Sensex) has grown from 1182 in Jan 1995 to 8264 in January 2015. However, you must notice Nifty has been able to perform well by chucking out bad performers and including winners. There is a lesson in Nifty behaviour. Nifty always has the best and largest companies from every sector. However, not all of them do well. This means even the best of companies may fail to meet the expectations. The makers of the index simply keep throwing out underperformers. That’s what you should do.
You may have picked up a company after doing a thorough fundamental analysis but decisions go wrong. Even Warren Buffet, arguably world’s greatest value and long term investor, has been candid about his mistakes in the shareholder reports. If the greatest investor in the world can make and acknowledge mistakes, why can’t you?
It is not easy to keep multi-baggers in the portfolio
Before a stock becomes 10-bagger (become 10 times the investment value), it becomes 2- bagger, 5-bagger and 8-bagger. To be honest, if I had invested lump sum in a stock, it would have been extremely difficult for me to wait till my investment became a 10 bagger. I do not know about others but I would have cashed out much earlier. The anxiety and the euphoria associated with booking profits would have undone me much earlier.
From what I have seen, it is easier to hold on to an investment which has given you returns of 20% than the one which has given you 100%. Why? Because no one wants to give up gains especially if the gains are huge and give you bragging rights. And the common refrain, the law of averages will apply, won’t it? What has gone up so fast will come down fast. Most of us think that way.
You are right too, at least in the short term. Stock prices do not move in straight lines. Prices move in waves. So the prices can go up and go down with the long term uptrend or downtrend being intact. Even for the best of companies such as Infosys and L&T have become hundred baggers this way only. So, once you are sitting on large gains, it is extremely difficult to see them get wiped off even if you are sure about fundamentals of the company.
Such approach towards investing is an anathema to a long term investor. But then, how many of us are truly long term investors? A lot of us claim to be but there are very few true long term investors.
Irrational expectations: You need money to make money
A lot of people come to stock markets for quick bucks. They want to convert Rs 1 lacs to Rs 10 lacs in a year. Making Rs 10 lacs may not be a difficult job if you have Rs 1 crores to invest. This is because Rs 10 lacs on Rs 1 crore is 10%. However, Rs 10 lacs on Rs 1 lac capital is 900%. Irrational, isn’t it? The problem is that most of us have absolute targets (and not percentage targets). A market participant with such irrational expectations is likely to take high risk calls (trading in penny stocks or even derivatives). He/she is more likely to lose entire capital than make such returns. No wonder, such a participant is likely to be disappointed soon and quit. I concede this point is more apt for a trader (and not for an investor) but a number of investors have irrational expectations too.
There is so much noise around
If you are hooked to any of the business news channel for making your investment decisions, you simply cannot be a long term investor. They will just not let you become one. If you get serious about the recommendations, you will buy and sell Infosys 10 times each every year. The reason is every analyst will have a different opinion about a company. Since those appear on television are considered experts (and a number of them are), their words have a big impact on you. You start doubting your research. No matter how good analysis you have done and are sure about the prospects of a company, negative opinion of an expert will make you worried. You will almost surely ignore your analysis and rely on his. I have no idea if Infosys makes for a good investment at the moment. However, I am sure for a company as large as Infosys, fundamentals don’t change that quickly.
Moreover, I feel the news coverage is focussed towards traders and short term tactical decisions. And you can’t blame technical analysts. They focus more on short term movements and less on fundamentals. If their charts point to a short term that can be taken advantage of, they will do so. You cannot blame the news channel too because they have to show what their viewers want to see. And most viewers are looking for quick returns.
Experience plays a vital part
If you have had bad experience when you tried to become long term investor, it is difficult to try hands at long term investing again. There are many stocks which are trading at 5% or even less of their peaks in 2008. Try explaining the virtue of long term investing to such investors who bought such stocks at their peak (or when the stocks were 25% or 50% off their peaks). Once bitten, twice shy. These things are more likely to happen to investors who hold concentrated portfolios.
How SIPs are better suited to long term investments?
Let’s see how Systematic investment plans (SIPs) in mutual funds can take of the problems discussed above.
About the ability for long term investing
SIP amount are decided based on your monthly cash flows and are better planned. All planners advise to build requisite emergency corpus and have an adequate health cover before you start SIP investments. Since SIP instalment amounts are typically decided after analyzing your cash flows, there are lesser chances of touching the MF corpus in case of an emergency. Of course, you may still be forced but planning reduces to risk.
Selling winners (and multi-baggers) and keeping losers
You brag about your stock picks but not about mutual fund picks. Fund manager is credited with outperformance and blamed for underperformance. You have little role to play apart from making those SIP instalments on time. Hence, it is easier to keep emotions out. It is easier to digest mistakes that fund managers make than the mistakes we make.
Rupee cost averaging ensures you do not sit on sharp gains very soon. For instance, in a market that has risen sharply, your first instalment might have doubled but your subsequent instalments wouldn’t have doubled. It is unlikely that SIPs will give 100% p.a. returns. This makes it easier to control your emotions and stick with the investment for the long term.
About irrational expectations
Give credit to business newspapers, television channels, personal finance blogs or industry education initiatives, investors do not look to double or triple their money in a year or two with mutual funds. Even the most optimistic of MF investors are happy with 15-20% p.a. returns. However, for the most of us who invest directly in stocks, 15-20% is just not worth the effort. You can see the return expectation bar is much higher when you are investing directly in stocks. These irrational expectations can cloud your judgement and investment discipline. With SIPs, there are no such irrational expectations and it is easier to stick for the long term.
About the noise of business channels
This world can go upside down but no analyst will come and say that equity investments will perform badly over the long term. Yes, they have an empirical evidence to back it up where equity investments have outperformed other asset classes over the long term. There is another reason. Most analysts represent brokerage houses. And brokerage houses make money when you trade. If they ask you to stop investing/trading, how will they survive? Therefore, for them, a rising market is a reason to invest before it gets too late and a falling market is an opportunity to accumulate.
Their outlook for the individual companies can be negative, but long term outlook for the equity markets in general will always be positive. Therefore, there will no differing opinion on the long term outlook for the equity markets. Your outlook is positive and theirs is always positive. Hence, you will not doubt yourself any bit.
About experience playing a part
Mutual funds diversify risk by investing in multiple companies. Of course, even mutual funds can perform badly. However, it is unlikely that they will see a value destruction of 90-95% as you do if your concentrated bets go wrong. So, even though you can lose money in mutual funds too, but the psychological scars won’t be so deep. Additionally, if you believe the long term trend is up, rupee cost averaging of SIPs works in your favour. To find more about this, please read my column in Business Standard
Long term investing works for the investors because the power of compounding works in their favour. However, the underlying premise is that the returns are positive. If the returns are negative, you are staring at significant loss of capital. Hence, staying in the investment product for the long term is not enough. You need to make the right investment choice too.
There are two pillars of success in long term investing: selecting the right investment and the Investment discipline. The way mutual funds and Systematic Investment plans are structured; both the aspects are taken care off. In my opinion, it is easier to select a good mutual fund than select a good stock. With the mechanical nature of SIPs, it is easier to keep emotions out and maintain investment discipline. So, it is easier to be long term investor through SIPs in mutual funds.
Credit: Started working on this post after reading a brilliant article from Uma Shashikant in ET Wealth (September 14, 2015 edition). You can read the article here.
Image Credit: Simon Cunningham/LendingMemo[dot]com, 2013. Original Image and information about usage rights can be downloaded from Flickr.
Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in