After explaining the difference between equity and debt in the previous part of this story, we explain the second reason to invest in equity for long-term. Nowadays, investors typically complain that even an SIP of four years in a typical fund has returns (depending on the fund) of perhaps three or four per cent. Four years is not an adequate period of time for an equity SIP. This is nicely demonstrated by calculating how such an investment would work out had the SIP been started earlier. If a SIP had started six years ago instead of four, it would have had returns of 8.5 per cent p.a. Had it been started eight years ago, the returns would have been 11 per cent per annum and had it been started ten years ago, it would have been 16 per cent p.a. This last rate of return corresponds to a 440 per cent total growth over a decade. Twelve years would have brought returns of 22 per cent p.a. And these are certainly not absurdly long periods of time. There are many investors who have sustained uninterrupted SIPs in equity funds for more than a decade and have generated such returns. They may have switched the actual fund as their quality varies but have never stopped the monthly investments.
The apparently magical power of long-term compounding and cost averaging on a volatile asset has to be experienced to be believed. Unfortunately, what investors latch on to are big upswings that are part of the cycle and then expect that to be smoothly sustained. Sure, stocks about doubled over 2004 and 2006 and then doubled again over the next two years but you can neither extrapolate that, nor predict. Such periods are just as atypical as the last four years have been. It's the average of the 2004-2006 kind of time and the 2009-2013 kind of time that you have to expect. And that averaging takes a decade or so.
The current downtrend is just a phase of the business cycle. It will end and another phase will begin. In fact, there is considerable evidence that it's the negative half of the business cycles that really sets up businesses (and their stocks) for growth. When the business cycle is on a high, its the time for unrealistic optimism, over-investments driven by heavy borrowings and what looks like instant success for fly-by-night operators. Even honest and sane business managers may be tempted to roll the dice a little too much, witness the overseas acquisitions of the Tatas and some others. Overinvestment eventually hurts everyone, even the well-run companies; the airline industry and high-end urban housing being excellent examples.
When the downcycle hits, its time to shape up. Businesses are forced to become more efficient, poor investments are abandoned and uneconomic businesses or poorly run businesses are shut down. This makes the survivors far more capable of generating outsize returns when the next upcycle comes. When equity investors start to appreciate how long the business cycle takes, and what really happens in the downcycle vs the upcycle, then they appreciate why it's important to carry on investing, regardless of what the last two or three or even four years' returns look like.
An excellent way of appreciating what long-term equity fund investments can get you is our analysis of 'Long running funds'. We review the life-time performance of five of India's oldest equity funds. These funds were launched between 1986 and 1994 and have seen multiple business cycles, as well as all manner of scams and bear phases that have afflicted the Indian equity markets. The analysis will be linked to this page soon.
And yet, not only have all of them beaten inflation handsomely, they have also beaten the Sensex comfortably. Despite the mandatory disclaimers on mutual fund advertisements, the fact remains that the past is the best teacher about the future. The only thing we have to do is to understand it, and draw lessons from it, rather than just expect it to be repeated.
This article was originally published on December 14, 2013.
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