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Here is a profound passage from the book Siddhartha by Hermann Hesse:

Merchant: “… If you are without possessions, how can you give?"

Siddhartha: “Everyone gives what he has. The soldier gives strength, the merchant goods, the teacher instruction, the farmer rice, the fisherman fish."

Merchant: “Very well, and what can you give? What have you learned that you can give?"

Siddhartha: “I can think, I can wait, I can fast."

Merchant: “Is that all?"

Siddhartha: “I think that is all."

When you first read these lines, they sound trivial. But the more you mull, you realize, maybe, that is all there is to being a good investor. Taking the liberty to modify a little bit, the journey towards becoming a good investor can be broken down into three steps:

1. Can you think?

The biggest detriment to good decisionmaking is our tendency to overweight narratives over evidence. As humans, we have an inherent tendency to make sense of the world through a neat cause-and-effect story and are not wired to appreciate randomness and uncertainty.

Sometimes, this compulsive habit of connecting the dots between random events grossly over-simplifies reality and underestimates the contribution of luck, leading to significant investment mistakes. Think about it, all financial bubbles are simply the case of a narrative taken too far.

A better approach is to start with the evidence, looking at data across the longest period possible and across markets. Once you identify patterns, you can check if they make sense from a logical or behavioural perspective. You will eventually build your own evidence-driven investment framework. These frameworks can be developed for different parts of the investment process—asset allocation, rebalancing, valuation, portfolio construction, and entry and exit strategies. Investment frameworks reduce the chances of getting carried away by narratives or emotions and make your investment process repeatable, leading to better outcomes.

Takeaway: Make decisions based on evidence-driven frameworks, not narratives.

2. Can you wait?

“The stock market is a device to transfer money from the impatient to the patient."—Warren Buffet

Equity investing for the long term boils down to our belief in human progress and entrepreneurship. We are simply betting that entrepreneurs (who take higher risks) on aggregate will get compensated with higher returns in the long run. As per the Credit Suisse Global Investment Returns Year Book 2021, which looks at the past 121 years of equity returns across countries, equity real returns (read as returns after adjusting for inflation) are 4-6% for most countries. So, it pays to be an optimist in the long run. That being said, the near term comes with its inevitable bouts of volatility. A shorter time frame, unfortunately, has the potential to transform temporary volatility into permanent loss. A long enough time frame and patience, on the other hand, allows the luxury to leave our portfolios untouched for most of the time, endure volatility and let the magic of compounding work.

Takeaway: Investing favours the patient optimist.

3. Can you suffer?

While equity markets mirror earnings growth in the long run, temporary market declines are inevitable in the short run. The last 40+ years of Sensex data shows that a 10-20% temporary decline in equities is almost a given every year. Occasionally, once every 3-5 years, equity markets can skid by up to 30%. While not so frequent, a temporary decline of 30-60% has historically occurred once every 7-10 years. Understanding history and setting the expectations around a market decline is one thing. But living through a bear market, where your hard-earned money is going down every day is a completely different experience. The real challenge is that all 10-20% declines feel like the start of a big market crash. Only in retrospect is it clear as to which one was the normal decline versus the crash. So, while the monetary cost in terms of expense is tangible, the real cost to be paid for long-term returns is not so evident—the emotional pain involved. This takes the form of uncertainty and sleepless nights. Your ability to stick to your portfolios for the long run will eventually depend on your capacity to tolerate the emotional pain of temporary declines.

Takeaway: Prepare to endure temporary market declines.

Arun Kumar M. is head of research, mutual funds at FundsIndia.

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