April 2017: “Be greedy when others are fearful” – easier said than done

The Nifty continued to strengthen and reached new highs during the month. It is also a rare month when markets were up despite the fact that foreign investors sold nearly $ 1 billion. In the absence of excitement in the real estate market and gold, domestic inflows into mutual funds have been robust and have absorbed any FII outflows.

Among the few key asset classes where investors can deploy their capital (equity, real estate and fixed income), equities have clearly performed well over the past several years, in addition to being tax efficient. Fixed income (debt) on the aggregate, has delivered returns less than inflation, especially after tax. An average Indian’s portfolio is much more loaded towards debt than equity, and this drags down the inflation adjusted post tax return of the aggregate investments.

Further, research suggests that even within equities, what an investor gets as return may vary widely from the underlying return of the market. A recent study by Dalbar on the US markets shows that over the past 30 years while the S&P 500 has delivered 11.1% pa, individual investors who invested in the US equity market during the same period made only 3.7% pa. The reason for the discrepancy is the aggregate investor’s desire to “time the market”. More money came into mutual funds and other such products during ebullient phases of the market and sadly money left the market during dull or ‘bear’ phases. The net result was that investors in aggregate made significantly less return than the underlying market return. Study results are similar for shorter periods also.

It is important to understand this behaviour, as it affects us all, and try to figure how one can counter this. Evidence suggests that investors don’t have the confidence to invest in equities when the sentiment at large is negative, and tend to buy into equities when everything looks bright. On the other hand, valuations are cheapest when sentiment is negative and expensive when sentiment is positive. As a result, investor returns are widely different from long term market rates of returns.

Sentiment in the equity market is governed by a wide variety of macro factors, which are very hard to decipher for even very smart people. However it is much easier to understand the micro factors which affect the long term prospects of a business and that is our area of focus. Of course, one can’t completely ignore the macro – one needs to monitor the environment for specific changes which can have an impact on businesses that one owns. However, a large chunk of the news that one reads and hears is just noise which needs to be ignored.

‘Be greedy when others are fearful, and be fearful when others are greedy’ are very wise words but it is easier said than done – even the best of investors have a tough time living up to these words. One way to handle this is to focus on proven businesses which have a sustainable competitive advantage, and have sufficiently long visibility of growth. Once there is a very high level of confidence in the underlying business and its long term prospects, our experience suggests that it is easier then to ride with the times, good or bad, and thereby reduce the risks of the costs associated with a frequent churn in one’s investments as described in the Dalbar study. So, before you commit capital to any equity strategy, ask yourself if you are confident that you can commit to the strategy through good times and bad.