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Returns Are Always Non Linear (Except In Fd!)

Sep 8, 2018 | Dr C K Narayan | Interesting Read, Long Term Impact, Market Related | No Comments

Returns Are Always Non Linear (Except In Fd!)

Returns Are Always Non Liner (Except In Fd!)

Everyone wants higher returns on their investments but no one wants the volatility that accompanies these returns. Since almost everyone invests into Fixed Deposits, their mind set is built around the smooth return curve that this asset class generates. Unfortunately, they bring the same mindset to equity returns and get perturbed when returns fluctuate. Hindsight bias works to a very high degree in the stock markets- we keep looking at what has happened to create views on what is likely to happen. Here too, people look at only the big winners but not how these returns were generated. Its like looking at Sachin’s batting and all the centuries that he has made but not at all his other innings where he failed to reach that figure (don’t forget that his career average is around 55 only!).

The more active you are in the market, the more you scoff at “reasonable “returns. What is reasonable? Lets fix it at 20%- something that is promised by every advisor and mutual fund and which, many would agree, is not overly difficult to achieve. But lets take a look at three charts of 20% returns over a longish period (15 years). Here is how three stocks made it to that return on a CAGR basis.

Here is Stock 1

Here we find a smooth return curve. Slight bit of volatility but nothing that one is not able to handle, is the thought that goes thru your mind. You are probably thinking that this is the ideal kind of picture that you want your stocks to depict! Just that wee bit of fluctuations to make it a little more exciting and interesting! People love this kind of stock returns as it gives them what they want (i.e. the return) with the additional thrill of some uncertainty in between.

 
Here is stock 2

The returns here were spectacular in a short period of time. But this happened mainly over the last 4 years. This meant that you had to be holding the stock for about 12-13 years in order to reap those benefits. These are the kind of stocks, if you own them, produce admiring glances from others but only you know the frustration of holding them for such a long time!

Here is stock 3

The returns are the same over the same period but look at the fluctuations! Most of the time, a majority of our stock holdings behave this way! Here again, we find that time needs to be given for the returns to show up.

Here is the thing. Recognising this aspect, value investing icons keep harping on the Time part, saying ad nauseum that you need to be in the stock for five or ten years to get the returns. All they are saying is what is obvious from the charts above. But what is left unsaid or no solution offered is- how do I handle the volatility? It is easy to say buy stock X and hold it for 5 years. But if that stock goes all over the place or doesn’t move at all for quite some time, what am I supposed to do? Stock chart 1 is easy to hold because it doesn’t fluctuate much and doesn’t consolidate for much. So every few days the price is ticking higher and that makes it easy to hold. But Stock 2 and 3 are more the norm- and unless we have some way of dealing with them, it would be very difficult to be in the stock from the starting point to the end. Perhaps, one can even manage to stick with stock 2- usually the dialogue used with these kind of stocks is that you must have ‘conviction’ to hold on to your good idea thru time. Easier said than done, buddy! Especially when there are so many other stocks that are zipping around and making money for other people! Somewhere along the way, almost everyone would abandon a consolidation stock to get into a mover. What is worse is that most of the time our stocks are like stock 3- whipping around every now and then. To stay with this kind of moves is the real deal.

So, what really emerges is not that it is only Time that produces the returns. It does. It is really OUR ABILITY TO WITHSTAND RETURN VOLATILITY that decides whether we are around to collect the returns. Picking stocks is not difficult. Many of the good ones perform most of the time. But if we have unrealistic ideas of how the returns will roll in then it will be very difficult for us to garner those returns.

Hence this extreme focuses on the stock’s fundamentals. Everyone wants to get it down to perfection by looking at every aspect of the company. But performance of the stock is also dictated to a good extent by the sector moves as well as the market trends. Sector softness or dullness will many times curb the trends in your stock even though it is doing well. If the market is down, your stock will also be down despite having very clear and very positive fundamentals. The decline in our markets from Jan thru June 2018 was market driven and not fundamental variables worsening. See the amount of damage that was wreaked on many stocks! Ask those that were holding stocks thru gut-wrenching 30-50% declines in their stock values.

This is an important facet to first understand and then accept as being a reality of equity investing. Else you can always stick with FD- where your post tax returns will be at 7% or lesser. We all want to go for more. But there is a lot that comes with the “more” territory! Are you ready for that?

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