If you are an active watcher of the stock market trends chances are that you must have heard the saying “Time in the market is more important than timing the market”, this saying essentially means that spending time in the market can yield one better returns than following the strategy of “attempting” to invest money when the market hits lows and pulling out just when the market touches its peaks. This post will try to test the first part of the saying, i.e. that is whether spending time in the market yields good returns or not.
Consider an investor who invested Rs 100 in a bank FD which promised to pay him 7% compound interest on 31st Dec 1979. The 100 Rs invested then would have become 761 on 31st Dec 2009. This can be seen using the compound interest calculator available at this link
http://www.moneychimp.com/calculator/compound_interest_calculator.htm
Other than the option of investing money in the FD, the investor could have chosen to follow the active index investing strategy i.e. money could have been invested in various stocks comprising the index in proportion to their weight in the index. Under this strategy whenever one stock in the index gets replaced by another the investor will have adjust the portfolio to reflect this change. However with the emergence of index funds in the year 2000 index investing is a job best left to the mutual funds. Index Mutual Funds relieve the investor from the pain of tracking the index, by taking upon them to maintain the portfolio that completely mirrors the index. The pdf attached(masterindexfund.pdf) shows the returns generated by the UTI master Index fund since inception. A cursory glance at the graph with the heading “Rs 100,000 invested at inception: UTI Master Index vs Sensex” gives a fair idea that the fund performance has mirrored the Sensex performance.
It will be hard to understand the essence of this post without the aid of the excel sheet attached ( Sensex.xlsx), So the readers are requested to open the sheet attached to this post. The column “C” in the attached excel shows the Sensex values on the last day of each calendar year since inception. For instance it can seen that the Sensex value on the 31st 1979 was 118 which 3110 on Dec 31 1995.
The column “D” shows the annual returns given by the Sensex from 1979 through 2009.
The cell E3 has a value of 38.4 this essentially means that Sensex gave average returns of 38.4% in the two year period from 31st Dec 1979 to 31st Dec 1981. Similarly E4 gives the returns generated by the Sensex portfolio from 31st Dec 1980 to 31st Dec 1982, likewise for other cells in the column E.
The column F gives the average Sensex portfolio returns over a three year period, for instance the cell F4 gives the average returns of the three year period ending December 1982 and F5 gives the average annual returns generated by the Sensex portfolio during the three year ending Dec 1983. Likewise for all cells in the column.
Finally since the data spans a 30 year period, it follows that there is only one average return for the full 30 year period i.e. 18.045. On the face of this figure looks slightly higher than the 7% returns yielded by a bank Fixed Deposit. But while with a 7% return a bank FD will turn Rs 100 to Rs 100*(1.07)^30 to Rs 760, at 18.045% return , the Rs100 will result into 100*(1.18045)^30 =Rs 17200(approx). Thus while a bank FD will expand your money only 6 times, an index investment would have expanded the money by a whopping 172 times. If we account for average Indian inflation rate of 7%, Rs 100 in 1979 is equivalent to 100*(1.07) ^30=Rs760 today. So, effectively remaining invested in the index for 30 years has multiplied the money by 17200/760(inflation adjusted returns) i.e. almost 23 times. Thus while money invested in FD may remain constant or may decline in value, it is quite likely that the value of money invested in equities would multiply manifold
Now we look at the probability of negative returns .
The following graph shows that if an investor stays invested only for one year there is a 26% probability that he/she would lose some of the money invested. However if the investor stays invested for 4 years the probability of negative returns is only 7.41 .i.e there is only 1/14 chance that an index investment will yield negative returns over a period of 4 years. Now, if the investor who can quit with negative returns after four years decides to stay put for 2 years more, he will end up with positive returns. Further no matter when you decide to invest and when the money is pulled out, the investor earns positive returns if she/remains invested for 6 years or more.
The graph below shows that if an investor invests for 15 years or more the probability of him/her getting less than 7% is zero. Also it can be noted with some exceptions that the longer the investor remains invested in the stock markets the lower is the probability of below bank returns. Also, 6 years into investment onwards the probability of below the bank always remains below 20%.
Moral of the story: In the long term equities generate a return far superior than some of the debt instruments available and the return differential that may look small on paper actually causes the money to grow significantly in the long run(i.e Rs 760 vs Rs 17200,take your pick!). Therefore even if you can spare a small amount of money which you think you will have no use for in the next 10 year, by all means invest in the stock markets. If don’t consider yourself to be an expert in stock picking restrict yourself to the purchase of Index mutual funds , sit back and watch your money and not your financial woes compound.
Acknowledgement : SOFIA thanks Selvakumar N(PGP2) for his efforts in giving us the year end Sensex values
Disclaimer: This post tries to arrive at the probabilities of negative and below Bank FD returns by using the past market data. SOFIA does not take any responsibility for losses arising due to following this strategy as the past market behaviour may or may not get repeated in the future.
Consider an investor who invested Rs 100 in a bank FD which promised to pay him 7% compound interest on 31st Dec 1979. The 100 Rs invested then would have become 761 on 31st Dec 2009. This can be seen using the compound interest calculator available at this link
http://www.moneychimp.com/calculator/compound_interest_calculator.htm
Other than the option of investing money in the FD, the investor could have chosen to follow the active index investing strategy i.e. money could have been invested in various stocks comprising the index in proportion to their weight in the index. Under this strategy whenever one stock in the index gets replaced by another the investor will have adjust the portfolio to reflect this change. However with the emergence of index funds in the year 2000 index investing is a job best left to the mutual funds. Index Mutual Funds relieve the investor from the pain of tracking the index, by taking upon them to maintain the portfolio that completely mirrors the index. The pdf attached(masterindexfund.pdf) shows the returns generated by the UTI master Index fund since inception. A cursory glance at the graph with the heading “Rs 100,000 invested at inception: UTI Master Index vs Sensex” gives a fair idea that the fund performance has mirrored the Sensex performance.
It will be hard to understand the essence of this post without the aid of the excel sheet attached ( Sensex.xlsx), So the readers are requested to open the sheet attached to this post. The column “C” in the attached excel shows the Sensex values on the last day of each calendar year since inception. For instance it can seen that the Sensex value on the 31st 1979 was 118 which 3110 on Dec 31 1995.
The column “D” shows the annual returns given by the Sensex from 1979 through 2009.
The cell E3 has a value of 38.4 this essentially means that Sensex gave average returns of 38.4% in the two year period from 31st Dec 1979 to 31st Dec 1981. Similarly E4 gives the returns generated by the Sensex portfolio from 31st Dec 1980 to 31st Dec 1982, likewise for other cells in the column E.
The column F gives the average Sensex portfolio returns over a three year period, for instance the cell F4 gives the average returns of the three year period ending December 1982 and F5 gives the average annual returns generated by the Sensex portfolio during the three year ending Dec 1983. Likewise for all cells in the column.
Finally since the data spans a 30 year period, it follows that there is only one average return for the full 30 year period i.e. 18.045. On the face of this figure looks slightly higher than the 7% returns yielded by a bank Fixed Deposit. But while with a 7% return a bank FD will turn Rs 100 to Rs 100*(1.07)^30 to Rs 760, at 18.045% return , the Rs100 will result into 100*(1.18045)^30 =Rs 17200(approx). Thus while a bank FD will expand your money only 6 times, an index investment would have expanded the money by a whopping 172 times. If we account for average Indian inflation rate of 7%, Rs 100 in 1979 is equivalent to 100*(1.07) ^30=Rs760 today. So, effectively remaining invested in the index for 30 years has multiplied the money by 17200/760(inflation adjusted returns) i.e. almost 23 times. Thus while money invested in FD may remain constant or may decline in value, it is quite likely that the value of money invested in equities would multiply manifold
Now we look at the probability of negative returns .
The following graph shows that if an investor stays invested only for one year there is a 26% probability that he/she would lose some of the money invested. However if the investor stays invested for 4 years the probability of negative returns is only 7.41 .i.e there is only 1/14 chance that an index investment will yield negative returns over a period of 4 years. Now, if the investor who can quit with negative returns after four years decides to stay put for 2 years more, he will end up with positive returns. Further no matter when you decide to invest and when the money is pulled out, the investor earns positive returns if she/remains invested for 6 years or more.
The graph below shows that if an investor invests for 15 years or more the probability of him/her getting less than 7% is zero. Also it can be noted with some exceptions that the longer the investor remains invested in the stock markets the lower is the probability of below bank returns. Also, 6 years into investment onwards the probability of below the bank always remains below 20%.
Moral of the story: In the long term equities generate a return far superior than some of the debt instruments available and the return differential that may look small on paper actually causes the money to grow significantly in the long run(i.e Rs 760 vs Rs 17200,take your pick!). Therefore even if you can spare a small amount of money which you think you will have no use for in the next 10 year, by all means invest in the stock markets. If don’t consider yourself to be an expert in stock picking restrict yourself to the purchase of Index mutual funds , sit back and watch your money and not your financial woes compound.
Acknowledgement : SOFIA thanks Selvakumar N(PGP2) for his efforts in giving us the year end Sensex values
Disclaimer: This post tries to arrive at the probabilities of negative and below Bank FD returns by using the past market data. SOFIA does not take any responsibility for losses arising due to following this strategy as the past market behaviour may or may not get repeated in the future.
Very well written And thanks for The Info .
ReplyDeleteAbhishek Khosla
i love this article....LONG TERM INVESTING is what a person should look for in stock markets... have patience... AND THE POWER OF COMPOUNDING(compound intrest) will do the rest...
ReplyDelete