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Investing for Long Term is not possible without building Conviction

When it comes to financial advise, everyone knows what is best for others even though one may not be qualified to handle their own money let alone other people’s money. From Fund Managers to your corner uncle who sells Mutual Funds, everyone believes that investing in real estate is a waste. Gold bugs believe that the doom is just around the corner and if you don’t hold gold and that too in Physical, you are doomed.

Insurance agents believe that investing in Insurance is not a hedge against something (Life / Health, etc) but a way to save money. Then again, if I am paid 20% of what you invest, I don’t think I would be complaining about it either.

On the equity side, we have fund managers who believe in different philosophies and refuse to accept that there is more than one way to skin the cat. So, while some vouch by value, some others vouch by quality. Some believe investing in small cap stocks is the way forward while others believe that you are better off with only large cap stocks.

For a long time now, Gold and Real Estate have been the chief investment products for a large majority of Indians. While it’s easy to decry and laugh at their stupidity in investing in assets, the fact remains that financial advisors generally do not have a clue as to why they do what they do.

Let’s take Real Estate for instance. I recently heard about a person who took a house on rent for a monthly rental that is 6 figures. I was wonder stuck as to why anyone would pay that kind of money till it dawned or rather was educated that despite the high rent, the annual rental was less than 1% of the property’s current worth. Add taxes and the real rental is a pittance on the current value of the asset.

On one hand, that looks stupid, but one also has to admire the conviction of holding onto the asset in a period when there is neither a capital gain nor rental yields. Which of course, brings the question back to market?

Since 1981, Apple has delivered a compounded return of 18% till date. But that kind of return comes with its own pain points. Below is the draw-down from its peak the stock has seen over time.

While draw-downs are one thing, the real killer is the time a stock spends in the draw-down. For instance, Apple hit a new all-time high in 1991, a high that wasn’t crossed till mid 1999 during the Infotech boom.

We have similar examples out here in India as well, from Hindustan Lever to Reliance Industries which have spent lots of time post hitting of a new high before the stock could go back to another new high.

What does it all point to?

For me, it just showcases that investing is not a simple affair where buying a good company can provide you great results. Good strategy can survive but only if you also understand the risk of the strategy in the first place.

Thanks to the enormous weight of FAANG stocks in S&P 500, Value Strategy has been an under-performer in US for a very long time. But should one even compare with S&P 500 if one is trading a strategy that is widely different to the underlying Index?

Would you race a dog and a horse and declare one to be the winner since both have similar body shapes and four legs.

In the world of factor investing, one of the major factors is the “Size Factor”. Size factor is calculated by taking the average return of small cap stocks and subtracting the average return of large cap stocks.

From 1927 through 2015, the US size premium was 3.3%. In other words, if you held a small cap portfolio from 1927, your return would have been higher by 3.3% compared to someone held a large cap portfolio in the same period.

Of course, the very fact that they out-perform doesn’t meant they do it all the time. In the same period of time, the probability of your portfolio under-performing a large cap portfolio after 10 years of being invested was to the tune of 23%.

Since 2013, markets had a tremendous run, more so for the small cap than large cap stocks. While the data showcases an outperformance of just around 3% per year, in this case, we had something like a 3x returns.

This was very well known not to stretch to infinity and beyond though every time it seemed like the rally would end it sprung a surprise. In February I wrote in my post, The Rout – What Now? And I quote

“By the time, the bear market got over, a lot of stocks had seen draw-downs from peak of 35 – 55%, a huge difference from the current falls of between 15 – 25%.”

Among stocks that trade on the National Stock Exchange, around 36% of stocks have fallen greater than 50% from their peaks, another 42% have fallen between 35% and 50%. In other words, nearly 80% of the market is now down from their peaks by more than 25%.

But as I tweeted out the other day, this way of looking at markets has issues. When a stock has risen from say 100 to 1000 and falls to 500, it has suffered a 50% draw-down yet is up 400% from the starting point. A case of Glass being half empty of half full.

Valuation is a better way to look at where markets are compared to where they started from. It’s been nearly 5 years since this rally started and one way to figure out whether markets are cheap or not is by looking at valuations.

The rally from 2013 happened due to two reasons – Reasonable valuation and Trigger of a shift in power from Congress to BJP which was till recently seen as the center of right party. The 2018 fall that has started has started with similar reasons – Unreasonable valuations and Trigger of a shift in power from BJP to who knows whom.

To add to worries we have the US Fed hiking interest rates and swapping up liquidity from the markets. Even here in India, growth of M3 as % of GDP has slumped sharply.

So, let’s move back to our original thesis – why do investors prefer Gold / Real Estate over Equity even though they are not fools to know that it won’t go up in a straight line? Why are they able to stay the course when it comes to Real Estate and Gold while the same person behaves differently when it comes to financial assets like Equity.

The answer in my opinion lies in conviction – they believe they understand better about Real Estate and Gold. This conviction didn’t come from seeing advertisements but from either experience of self and close friends.

AMFI has been funding big time advertising the merits of Mutual Funds under the “Mutual Fund Sahi Hai” campaign and I would give it a lot of credit for the shift we have seen in recent times. But what really helped the campaign was not just that the other asset classes were showing weakness even as equity was delivering.

At best, to me this is borrowed conviction and one that is not easy to sustain if the market undergoes a long and painful correction. At Capitalmind we recently wrote about Insurance and one chart was deeply troubling – more than 50% of the policies closed out by the end of the 5th year.

Once again, massively misselling means that while its easy to get people in, sustaining them is pretty tough. Would equity mutual funds turn out to be any different?

My guess is as good as yours though I believe that the only people who shall stay is who aren’t swayed by the advertisements but have understood the importance of having equity in their asset allocation matrix.

Finding the edge that works for you is not an easy task and one that can years and decades. But once conviction is build, its easier to deal with stuff like draw-downs and volatility. Till that time, one keeps jumping from one queue to another since one’s queue always seems to be not moving.



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