Thinking Long Term

Just to recap, in our Weekend Bytes – “Key Tenets to Reduce Risks While Investing in Equities”, we discussed the importance of diversifying within equities. While a key risk of investing is managed through this approach, creating wealth requires thinking beyond just diversification.

As quoted by Jack Bogle – “Invest for the long term, not for the short term. Time is your friend, impulse is your enemy!”

Better said than done though? The reality is that although equities have the potential of providing growth in the long term, the short term poses risks. With that in mind, let’s have a look at the next tenet that an investor should consider when allocating to equities:

Tenet 2: Thinking Long Term

What stands in the path of thinking long term?

• Equity markets do not move up in a linear fashion – they are unpredictable
• In the short term, market volatility tends to cloud investors’ judgement, causing them to act hastily with their investments

Short Term and Long Term – A Tale of 2 Stories

• Short Term: Chart 1 shows S&P BSE Sensex giving positive returns in some financial years, and negative in other financial years
• Long Term: Chart 2 shows S&P BSE SENSEX beating the average inflation rate, delivering a Compounded Annual Growth Rate (CAGR) of 15.4% between March 1980 and January 2023

In the short term, various news and events, domestic and global, drive the equity markets. Such scenarios can lead to disproportionate profits or losses, causing investors to lack the discipline of holding onto their investments for a longer investment horizon.

But, in the long run, equity markets tend to become less volatile because markets tend to deliver returns in line with the profit growth of companies, which in turn is a function of the underlying economic growth (Discussed in our earlier Weekend Byte The Linkage between GDP, Earnings and Markets). For better understanding of the movement of the equity markets in the long run, let us have a look at the table below.

As we can see from the table above, with the rise in the investment horizon, the probability of gains increases.

For example, the probability of 10-year and 20-year rolling returns of S&P BSE Sensex being greater than 0 is 100%, while the probability of 1-year rolling returns of S&P BSE Sensex being greater than 0 is only 77%.

Conclusion

To remain resilient for the long term, investors need to wade through the volatility of the equity markets in the short term. To do so, they need to ensure the following:

• Adopting a portfolio approach by diversifying within equities (Discussed in the previous Weekend Bytes)
• Remembering that strong linkages between markets and profits correct divergences in the long term
• Remaining patient in order to unlock the true potential of compounding in the long term

But are satisfying the first 2 tenets – diversification and thinking long term, enough to reduce risks while investing in equities? Tune in for the next edition for this series to know more!

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