BackPlaying The Long Game
On long-term investment strategies
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I want to invest for my kid’s college education, where should I invest?" This is one question often asked at social gatherings that leaves me slightly nonplussed. It is the equivalent of asking a doctor at a party to prescribe you something for the pain. Just as the doctor can’t give a medical opinion without examination and looking at your medical history, no one can give investment advice without knowing your portfolio, investment aims and horizon.
With Diwali and Diwali parties round the corner, I thought it would be better to write an answer to pre-empt such questions. Since even the columns dispensing gratuitous financial advice are hamstrung by this inability to tailor-advice for unknown readers, it is better to focus on the process rather than the end result. Therefore, applying the Gita to finance, I shall lay out the analysis of an investment thesis rather than opine on whether the market will go up or down or which asset class will outperform. This way, you the investor, can use the insight into the investment process and adapt it to meet your own objectives.
Most people set aside funds for their kids’ college education or to provide them with a head-start in life. These are long-horizon investments over a 15-20 year period where traditionally the money was invested in either fixed deposits or in gold. But increasing financial choice and awareness has made the decision more complicated. How should you invest to maximize the value of the gift to your kids?
Since long-term investments are fundamentally different from the ones that you make in your portfolio daily or monthly, their analysis requires different metrics. There are three critical factors to be kept in mind. The first is that real, i.e. inflation adjusted, returns matter. If your investments double but the price of everything trebles then your wealth has actually reduced. Moreover, the inflation that you need to consider is not general CPI numbers but prices of things that you hope to buy from investment returns. For example, as graph-1 shows, the cost of sending your kids to the US for college education has increased much more than general inflation in India. Depending on where you had invested 18 years ago, your child may have enough to defray tuition fees (gold) or he may also have a sizable buffer for living expenses (stocks, PPF).
Finally, keep in mind that the inherent unpredictability of investment is magnified by the long time period under consideration. To appreciate this, you need to only look at how the margin of error between economic predictions and reality increases with time period. Remember those television ads in the late 1980s that predicted oil would run out by the current decade? If you’d invested in nuclear power companies around that time you’d have been sorry. As economist J.K. Galbraith said, “There are two types of forecasters: those who don’t know and those who don’t know they don’t know." The long-term investor needs to be the former and avoid catastrophic losses born of overconfidence. To handle this unpredictability of future outcomes, one requires focusing not only on how great the returns will be if his expectations materialize, but how greater the losses will be if they don’t.
Once you understand the factors above, how do you go about choosing a specific investment? There are three main rules that must be followed. First, as an investor, you must understand what you’re investing in. Second, invest at a fair price. And finally, keep costs under strict control.
These rules sound simple but are difficult to put into practice. Take the first two rules about understanding the investment and investing at a reasonable price. The highly publicized debacle of Facebook’s IPO (or Reliance Power closer home) is testament to the lack of analysis done by investors. Asset popularity and current fashion usually dictate investment choices. Behavioural finance shows that instead of being rational, investors are easily swayed by emotion and prefer shortcuts to extensive analysis in reaching investment decisions. The last two booms—dotcom and housing—led investors to pile into a “new investment paradigm" only to realize significant capital losses. After 12 years, the Nasdaq is still about 40% below its peak. This neatly illustrates how the siren song of “hot" asset classes makes investors forget due diligence and the principle of buying at a fair price. Such lapses are costlier for long-term investors than for short-term investors. This is because like unpredictability, errors compound over time. A wrong decision to buy a stock for a day trade may cost a few thousand rupees, but a wrong decision of investing in IT stocks in 1999, instead of opening a fixed deposit, would have cost several lakhs of rupees in lost returns over more than a decade.
Keeping costs in check is an extremely important but often ignored rule. Returns to the investor are critically affected by entry, exit, fund management and other charges levied. A look at graph-2 shows the massive reduction in return that fund management costs can impose. Paying a hedge fund 2-and-20 for performance which mimics the Sensex leads the investor to capture only 45% of the upside over 19 years. Even if the fund manager beats the Sensex by 4.5% every year for 19 consecutive years (highly unlikely), the investor only manages to capture 91% of the upside. Amazingly, for the investor, returns from such a hypothetical “market guru" would still be slightly worse than an ETF with 0.5% annual costs.
In conclusion, the key takeaways for a long-term investor are that you must invest on the basis of your aims and not let short-term market fluctuations distract you. However, be aware of your own fallibility in predicting the future. To minimize adverse investment consequences, avoid ephemeral investment fads. Do your own homework to understand the asset class and asset you’re investing in and the price at which it is sensible to invest. Last of all, never forget that even small costs add up and produce a big difference in returns.
All of these are not very different from the precepts of Warren Buffett who famously declared his holding period to be “forever". Your child’s college fund could do worse than perform like Berkshire stock..
Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.
Reliance Power has sued HT Media Ltd, publisher of Mint, in the Bombay High Court over a 12 May 2010 front-page story in Mint that it disputed. HT Media is contesting the case
Respond to this column at indulge@livemint.com
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