The incredibly simple investing technique for Zero Capital Loss!

May 18, 2015

In this issue:
» Sensex rallies on monsoon forecast. Should value investors buy into such information?
» Lowest sales growth reported in the latest earnings season in last 16 quarters!
»  ...and more!

 Chart of the day
A few weeks ago I had written about the '5 crore wala' mindset based on an interesting interaction I had with an investor. It was about how quite a many small investors waste incredible amounts of time and energy asking petty questions that are not going to make any significant impact on their financial health.

There's one more thing that I want to talk about today. If you would have noticed, many investors are a bit too focused on 'buying' stocks. They seem single-mindedly driven by just one question - What should I buy now? Which stock will be the next quick multibagger?

And once they have bought some stock, a different set of questions start dominating their minds - When should I sell? Should I sell now? Should I book profit before the stock price falters?

I'd like to call this tendency the 'action itch'. I am calling it an 'itch' because I see that in many cases investors keep looking for stocks simply to have some action and thrill. Trust me, they will never admit this. Sometimes, they may not even be consciously aware of this kind of behavior. But deep within our subconscious, there is an old programming that correlates action with success and survival. Conversely, inaction is almost seen as a taboo.

Enter the world of investing and the rules of the game change drastically, almost 180 degrees! Here, too much action can be dangerous.

In investing, doing less is more...

If you keep jumping in and out of stocks, you're broker is going to become rich. Not you.

If there's one person who knows the true value of being passive, it is Warren Buffett - the world's most successful investor. He once said, "Wall Street makes money on activity. You make money on inactivity."

Why is inactivity important in investing?

Let me explain. Unlike fixed income securities, stock market returns are non-linear. You cannot predict when your stock will double, or when the markets will come down crashing. In the short to medium term, stock prices can fluctuate wildly away from their intrinsic value. However, over the long term, stock returns will reflect the underlying business fundamentals.

So what should you do if you want to save your portfolio returns from the erratic movements of the markets? What is the key to real riches in the stock markets?

The answer is - Be a passive long term investor.

And if you are still not convinced, I have some very compelling data that Rahul Shah just shared with me. Interestingly, he has been studying market movements and stock returns over different time horizons and how value investors can take advantage of the wild mood swings of Mr Market. He gathered BSE-Sensex data from 1984 to 2014 and formulated a simple hypothesis: If an investor were to invest in the BSE-Sensex at the end of each year starting 1984, how would his returns be across different time horizons?

The chart below shows the range of compounded annual returns that the Sensex has delivered across different time frames. So let's say you have a one year investment horizon. During the 30 year period, there would have been years when your investments would be up substantially. But then there would also be a 30% chance of capital erosion. If you had invested at the end of 2007 with a one year investment horizon, a year later your portfolio would be down more than 50%!

Which Is The Best Time Horizon For Investing?
Note: Time period considered from December 1984 to December 2014

You can see from the chart that as your time horizon expands, the volatility in the Sensex returns drops drastically. In fact, if you had an investment time horizon of 10 years or longer, you would see 'ZERO CAPITAL LOSS' on your Sensex portfolio.

In our view, the investing game need not be too complicated. You don't need to be a rocket scientist to identify businesses with strong fundamentals. Pay a price that the fundamentals justify. Have a diversified portfolio because you will not know in advance which stocks will outperform or underperform.

Once you have done this, all you have to do is to 'not do' anything.

Be patient. Be passive. Keep the 'action itch' under control.

And the power of compounding will work its magic for you.

According to you, which is the ideal investment time horizon? Let us know your comments or share your views in the Equitymaster Club.

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The impact of monsoons on Indian economy can hardly be overstated. After all, agriculture output comprises 14%-15% of the GDP and over half of the country's population is dependent on the same. No wonder monsoons casts a ripple impact on Indian economy and are a part of disclaimer whenever any economic growth forecasts are made.

But as far as equity markets are concerned, the impact of monsoons seems to be quite asymmetric. Historical data suggests that monsoons have little bearing on the markets. In the past, the Sensex has returned double digit returns in the year when the rainfall was most deficient as compared to the long period average. That said, markets are quite enthusiastic about the recent forecast of a timely monsoon, unwary of the consequences of a below normal rainfall for the second consecutive year. Of course, there are other factors to influence market sentiments as well - most notable of them being hopes of a rate cut by RBI.

However, being the proponents of value investing, such announcements and market reactions have little impact on our investing decisions. For these factors have little impact on intrinsic value which is a function of cash flow generation over the long term... for which events like monsoon forecasts and rate cut announcements are insignificant...Unless they work in a way to offer a huge gap between price and value of the stock. We believe that investors too would be better off not to focus too much on such announcements and reactions and instead focus their efforts to pick undervalued stocks.

The recent earnings season has been an eye opener in the times when blind optimism has been swaying the markets. While a lot of recent volatility in the markets is attributed to FIIs' declining interest, the statistics back home does not look bright either.

As an article in Livemint suggests, this has been a quarter of lowest sales growth in last 16 quarters, underscoring the lack of demand in the economy. The data set includes 142 companies of the BSE 500 index and excludes the company in the banking sector... which itself is slipping further in the bad debt mess and might have made the picture look even worse. The other sectors being excluded are IT and energy.

So while the sales growth of these companies is a mere 5.1%, overall net profit is down 11.8% - first decline in the last six quarters. Will the future quarters be better?

The pace of economic reforms has hardly matched the expectations. The key sectors in the economy - banking, infrastructure and metal etc. are likely to take longer to turn around. The infrastructure sector is still reeling under heavy debts. Huge interest payments at time when projects are still stalled and cheap imports from economies like China are further playing spoilsport. On the top of that, there are factors such as weak rural demand, volatile currency and other global factors that can turn unfavorable leading to a longer wait for the economic recovery. As such, investors would do better to keep these ground realities in mind and avoid getting carried away by momentum in the markets.

The Indian stock markets regained further ground after opening the day on a positive note. At the time of writing, the Sensex was trading higher by about 247 points or 0.9%. Barring realty sector, stocks across the board were trading in the green with oil and gas and healthcare being the top gainers. The midcap and smallcap indices gained around 0.6% and 0.8% respectively.

 Today's investing mantra
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

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