• SEPTEMBER 8, 2004

Have you gone long-term yet?

Invest. The dictionary meaning of this word is "to commit money in order to earn a financial return". And the capital that you invest is your investment. Now consider the meaning of the word speculation, which is "to assume a business risk in hopes of gains, e.g. to buy/sell in 'expectation' of profiting from 'market fluctuations'.

Every market consists of both the above kinds i.e. speculators as well as investors. While the former makes money (if they ever do) on the basis of luck, hope and expectations, the latter (i.e. investors) takes calculated risks backed by research. Further, while the former has the aim of taking advantage of market irrationality and market fluctuations, which may or may not work in his favour, the latter intends to reap the benefits of a growing industry and business and has a relatively much lesser chance of going wrong. However, a recent amendment in the Finance Bill aims to convert some of the speculators into investors.

The recent changes in the Finance Bill have come as a boon to equity investors in particular and Indian stock markets in general. In this years Budget, the Finance Minister has not only removed equity profits from the purview of long-term capital gains tax (previously 10%) but has also reduced the short-term capital gains tax to 10% (previously as per an individuals tax bracket). It must be noted that for equities, long-term would mean holding equities for a period greater than 1-year. Anything below that would be categorized as short-term. These amendments offer a considerable saving for a long-term investor as he now has to share NIL or lower part of his profits with the government.

On the basis of the above, we recently conducted a poll on Equitymaster wherein we asked our readers, "Will your investment horizon increase considering the exemption of long-term capital gains tax?" While the outcome of this was not a surprise to us, it was the magnitude of the response towards a particular option that took us aback somewhat. This is because nearly 80% of our readers who took the poll voted a "Yes" i.e. their investment horizon would increase in the no-tax on long-term capital gains regime (it seems that the Finance Minister has made a good start in converting speculators to long-term investors thus not only improving the investors' quality of earnings from the stock market but also helping mitigate the volatility risks to investors in particular and the stock markets in general). The astounding positive reply was followed by 18% of those who, seemingly, continued to believe that it is better to trade. The rest (2%) were indecisive.

And, where do we stand on this? Definitely and unquestionably on the long-term investment side. This is because we feel that there are a number of advantages of long-term investments, which can be better understood by considering the negatives of short-term trading. First and the most basic argument is the savings on the tax front, wherein in case of long-term, whatever profits you earn need not be shared with the tax authorities against a 10% in case of short-term gains.

Second, in case of frequent trading, an investor will have to bear many costs over and over again like the recently introduced transactions tax (0.15%), the brokerage costs, which are in the vicinity of about 0.5%-1% on delivery based trades and demat charges every time the securities pass in and out of your demat account.

Another disadvantage of short-term trading is that investors seem to think that they are above the markets and they will be able to outperform the markets and will be able to catch the peaks and the bottoms of the market. However, here, while we believe that it is nearly impossible for any investor to do this, we think that the possibility of a short-term investor getting caught on the wrong foot is relatively much higher.

Of course, investors must understand that long-term investment does not mean an absolutely passive investment style. However, it also does not mean active/frequent churning of your portfolio. An investor should consistently keep in touch with the developments in the industries to which his stocks belong to and keep his eyes and ears open to any potentially adverse development that may warrant a de-rating/selling of the stock.

At this juncture, it would be most appropriate to bring out an extract from the legendary investor, Warren Buffet's letter to his shareholders in 1985, which read, "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks." In other words, this should be construed as a warning to investors who tend to get emotionally attached to their investments and tend to resort to averaging of their holdings with the hope that the investments might pay off, which may not be the correct decision always.

In another of Warren Buffet's letter to his shareholders in 1984, he remarked, "We feel very comfortable owning interests in businesses...that offer excellent economics combined with shareholder-conscious managements." The important words that an investor must always keep in mind here are "owning business" i.e. buying stocks of a company with a long-term investment commitment and this is possible only when one understands the business. Another set of important words is "shareholder conscious managements", which we believe is amongst the most important criteria for investing in the stock markets. An investor must understand here that however strong a business model may be, the company's ability to ward off threats, build on its strengths, overcome its weaknesses, explore and take advantage of available opportunities and be competitive depends solely on the management acumen.

Last but not the least, investment allocation based on one's risk-return profile, avoiding greed and fear, remaining focused on long-term investment, refusing to get hypnotized by market perceptions, keeping faith in your investments and avoiding giving effect to irrational, hasty and irresponsible decisions are just some of the qualities required to be successful in equity markets. Remember, while short-term trading is "hazardous to your wealth", over the long-term, one has a better chance of mitigating the risks involved in the short-term.

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