Can you really make money by investing at a peak?

Statistics suggest that most Indian investors in equity funds make most of their investments in bull markets.  As someone put it, “Rather than buy low and sell high, most investors attempt to buy high and sell higher.”  So, what are the chances of making money by doing so? 

Obviously, it depends on how much money one is looking at making, and over what time frame.  While I don’t have a crystal ball or any other means to know what the future may hold, in this post, I propose to examine some historical evidence.

In a way, I had skimmed the fringes of this in an earlier post, where I attempted to make the case for equity funds serving a certain purpose.  To do so, I had looked at the NSE-50 Total Return Index and had examined the outcomes from hypothetical investments made in this index each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates representing market peaks).  This period covered 2682 trading days.  The trailing P/E ratio ranged between 10.68 and 28.47, with a median of 18.10.

In this post, I propose to use the same data and examine the instances of making varying levels of returns by investing on 211 peak days i.e. days on which the index was at, or near, a peak in terms of price as well as valuations (these days were amongst the top 20% in terms of the trailing P/E ratio and also represented either a new price high or were not more than 10% below the last price high).

The performance has been analyzed up to 19 Sep, 2014.  It would be pertinent to point out that of the total 2682 days, there were 281 days on which, if an investment were to be made, would not have completed 5 years on or before 19 Sep, 2014.  Of the shortlisted 211 days, there were 48 such days.

Here, then, are some of the observations:

Across the 2682 days, investments made on 1283 days could have, on completion of 3 years, resulted in an appreciation of 15% p.a. or more.  Of the 211 peak days, there were only 21 days when an investment could have seen similar results.

Overall, there were 1366 days on which an investment, if made, could have, on completion of 5 years, seen an appreciation of 15% p.a. or more.  There wasn’t a single peak day, investing on which this would have been possible.

What if, instead of a buy-and-hold strategy, one were to have actively monitored one’s portfolio and cashed in the gains?

An annualized return of 15% p.a. over 3 years equals a total return of 52.1%.  An annualized return of 15% p.a. over 5 years equals a total return of 101.1%.  Of the 211 days, there were 41 days, investing on which, one could have seen a cumulative appreciation of 52.1% in 3 years or less.  These included 21 days, investing on which, one could have seen a cumulative appreciation of 101.1% in 5 years or less.  

The tables below give a more detailed set of observations pertaining to investments made on the 211 peak days.

Targeted  Return	Instances of achieving targeted return by holding for exactly
	1 year	3 years	5 years
30% p.a.	19	1	0
20% p.a.	20	21	0
15% p.a.	26	21	0
10% p.a.	32	33	9

 

Targeted Cumulative Return	Instances of achieving targeted return in a period of
	5 years or less	3 years or less	1 year or less
10%	184	115	92
20%	144	68	48
30%	133	55	34
40%	101	45	24
50%	49	41	20
60%	40	24	0
70%	24	24	0
80%	22	21	0
90%	21	21	0
100%	21	21	0
120%	21	14	0
150%	21	0	0
200%	21	0	0
250%	12	0	0

In case you have difficulty relating to cumulative returns, here are some quick indicators:

A cumulative return of 100% is approximately equal to a compounded return of 15% p.a. over 5 years, or 26% p.a. over 3 years.

A cumulative return of 150% is approximately equal to a compounded return of 20% p.a. over 5 years, or 36% p.a. over 3 years.

A cumulative return of 200% is approximately equal to a compounded return of 25% p.a. over 5 years, or 44% p.a. over 3 years.

A cumulative return of 250% is approximately equal to a compounded return of 28% p.a. over 5 years, or 52% p.a. over 3 years.

One final observation: there were dates on which, investments made and held,  would not have achieved a modest targeted return even over periods beyond 5 years.  For instance, investments made on certain dates in Oct, 2007 and Nov, 2007 would not have seen an appreciation of 8% p.a. at any point over the last six-odd years.  As of 19 Sep, 2014, these investments, if made and held, would have registered an annualized return between 6% p.a.-7% p.a.

Based on these observations, I am inclined to conclude that investing at, or close to, market peaks is fraught with considerable uncertainty.  While it may have been possible to generate returns as high as 50% in a period of a year or less, or in excess of 25% p.a. over a period of 5 years, such opportunities would have been very, very few.  The evidence suggests that there were far greater instances of, at best, generating single digit returns over the short term, and annualized single digit returns over the long term.

If at all one still chooses to make investments at similar peaks, I would recommend investing in a staggered manner, such as through a Systematic Investment Plan.  Further, I would suggest one set modest return expectations, actively monitor the returns and cash in and/or average out, as and when opportunities present themselves.

The new usefulness of equity funds

This isn’t for everyone, so unless you are confident that you understand the risks involved and are willing to live with a potentially unfavourable outcome, don’t attempt this on your portfolio without consulting a good investment advisor.

Till recently, for investors in the higher tax brackets, with an investment horizon of between 1 and 3 years, debt funds were arguably the most attractive investment option, in terms of potential return that could be earned, relative to the risk.  In the wake of the taxation changes announced in the recent budget, these funds are now, more or less, as attractive (or unattractive) as any other debt instrument.  The taxes that such investors would now have to pay in these funds could well be up to three times (or even more) what one would have paid based on the earlier tax laws.  This would also be the case for investors who have already made investments in debt funds and need to withdraw some or all of those investments, some time after the completion of 1 year (from the date of investment) but before the completion of 3 years from that date.

For all such investors, who are uncomfortable with the additional tax now needed to be paid, I would like to propose the case for a greater allocation to equity oriented funds.  A note of caution: Equity funds are not a natural substitute for debt funds or any debt instrument.  These require far greater risk management as compared to debt funds, and it would help to bear that in mind while evaluating this.

The background: According to the new budget proposals, gains from exiting a debt fund before completion of 3 years will now be taxed at one’s normal tax rate.  Gains from exiting an equity oriented fund after completion of 1 year continue to be tax-free.  At the time of writing, a deposit with State Bank of India for a period of between 1 and 3 years, is assuring an annualized return of 9.31% p.a.  If taxes were to be taken at 30%,  then this roughly translates into a post-tax return of 6.52% p.a.  One could say that an equity oriented fund needs to produce returns in excess of this number for it to be a more worthwhile investment.

The case: To understand the odds, I looked at data of the NSE-50 Total Return Index, and tried to examine the outcome from making a hypothetical investment in this index on each day between 11 Feb, 2000 and 5 Nov, 2010 (both dates represent market peaks).  More specifically, I tried to see how long would it have taken such an investment made on each day to deliver an annualized return of 7.00% p.a., after taxes (subject to a minimum absolute return of 7.00%, after taxes).  Tax (on investments held for less than a year) was assumed at 15%.  Here are some of the key observations:

• Of the 2682 trading days in this period, there were 2207 days (82%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   
• There were 1864 days (70%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 180 days or less. 
• There were 621 days (23%) on which,  if an investment were to have been made, would have resulted in this target return in a period of 30 days or less.  
• There were 179 days (7%) on which, if an investment were to have been made, it would have taken over 3 years to achieve this target return.  These include 43 days on which, if an investment were to have been made, this target return would have not yet been achieved (as on 30 June, 2014).  
• The longest wait to achieve this target return would be for an investor who invested on 29 Oct, 2007.  As on 30 June, 2014, he/ she would have waited 6 years and 8 months.  As on that date, the return on his/ her investment would have been 5.06% p.a.
• There were 1754 trading days on which the trailing Price-Earnings (P/E) Ratio of the NSE-50 was below 20.  An investor who invested on any of these days would have had to wait no longer than 2 years and 11 months to achieve the target return.  Of these, there were 1553 days (89%) on which, if an investment were to have been made, would have resulted in this target return in a period of 1 year or less.   

In case you think there is a case for using this information to formulate a strategy, here are some suggestions:

• I believe that the primary motivation for using this information as part of a strategy should be to bring down taxes.  This will help determine how much should be additionally allocated to equity funds.  Any motivations beyond that should be carefully assessed before moving ahead. 
• Judiciously pick the moments when you would want to allocate money to equity funds.  The P/E Ratio can be a good indicator.  In addition, I would also consider how much below the last peak is the index.
• Don’t defer your exit from an equity fund till the time when you need the money.  If, at that time, prices are down, it may have far more adverse consequences than you may realize. 
• Do bear in mind that any gain from exiting an equity fund before the completion of 1 year is not tax-free.

At the time of writing, the P/E Ratio of the NSE-50 stands close to 21, and markets are around their all time high.  Personally, I would use this as an opportunity to exit equity funds to the extent that I can anticipate a need that would otherwise increase my tax liability.

Is this a good time to invest in equity funds?

In my opinion, for anyone contemplating investing into an equity fund, this is as good a time as any to do so, provided one puts in place some kind of a safety net, so to speak. 

While it is true that stock prices have risen significantly in the last several months, and the valuations are not as attractive as, say, a year ago, these facts are now a part of history and cannot be re-written.  But should we wait for a more opportune moment? No matter what anyone may say, only time will tell us how remunerative any decision taken today will be.  Going forward, it is possible that we may look back and wish we had waited a while before investing.  It is equally possible that we may look back and regret not having invested at this point. 

What is probably more important is that we plan with an awareness of the risks that could accompany our investment decision.  I, for one, regard stock markets with the awe and respect that I reserve for forces of nature.  Any attempt that I make to harness their power is done while taking as many precautions as I can, with the knowledge that there is still the possibility of being overwhelmed.  Equity funds give our portfolio the potential for appreciation, yet their price fluctuations can be unnerving for most of us.  Panic in a downturn is a key reason for investors missing out on the benefits from equity investing.  In the event of a steep or sustained fall, most of us will inevitably grapple with discomfort.   Here are some things that we can do to soften the impact:

Know how much to invest: Investing is not an end in itself but a means to an end.  Having well-defined financial goals can help determine the extent of investment that we should have in equity funds, and it is best to keep our investment within that limit.

Plan to stay invested for as long as possible: A number of experts suggest that equity investments should be planned with a minimum time horizon of 5 years.  This is usually attributed to the fact that historically, business/ market cycles (peak to recession and back) have lasted, on an average, for 5 years or so.  I am not an expert on this but I look at this as a reasonable rule of thumb, nothing more.  From the evidence that I have examined, the only somewhat conclusive inference that I can draw is that the longer we hold, the lesser are the chances of unpleasant surprises.

Avoid investing a large amount at one go: If investing a large amount, consider doing so in small tranches rather than at one go.  This helps protect against the soreness that one is likely to feel in the event of a sharp fall in prices shortly after initiating the investment.

Looking for a good equity fund? Ask your advisor

Over the years, in conversations with people whom I met outside my work, I have often been asked to recommend a good equity fund to invest into. Once upon a time, I used to respond by whole-heartedly listing the funds that I believed to have the potential to deliver above-average returns over a period of 5 years or more. It would be an honest answer but the underlying assumption behind my response would be that it was an academic question, driven by the demands of polite conversation. Not for a moment did I think that any one of these people would ever act upon what I said. As it turned out, I was wrong.

I came to realize that a number of investors actually sought out funds to invest into, through random conversations with multiple investment professionals. More worryingly, I realized that a number of them did not have the temperament needed for successful equity investing. For instance, they exhibited the tendency to invest significantly during periods of mass euphoria and refrain from investing when prices were most attractive. Probably, worst of all, quite a few jeopardized their investment goals by not exiting these funds as their goals approached.

These observations triggered a few questions within me. What was the point of good returns if you didn’t get them when you needed them? What should an investor do to maximize the chances of meeting his/ her objectives? Could there really be a single fund that could help an investor do so?

I have, since, revised my response to anyone who asks me to recommend an equity fund. I present below the broad strokes of what I now say, and the beliefs supporting it.

Asking someone to recommend a good equity fund is somewhat like asking someone to recommend a good, strong medicine. Neither should be taken lightly. Medicines are best prescribed by a doctor who thoroughly understands the patient’s condition. Similarly, equity funds are best recommended by a trusted investment advisor who understands the investment objectives of the client and his/her psychological ability to handle market fluctuations, amongst other things. Done correctly, the chances are that the recommendation will have multiple funds, and will include equity and debt funds. Equity funds, on their own, have a clear limitation in their ability to protect downside risk. In 2008, for instance, the fall in the NAVs of a number of equity funds was so steep that it wiped out the gains accumulated over the preceding 2 years. Such a period of negative performance closer to the point when one needs to withdraw money could significantly, adversely impact the purpose for which the money is needed. In fact, more than the choice of individual funds, the quality of an advisor’s recommendation will hinge on the appropriateness of the mix of equity and debt funds at any given time, technically referred to, as ‘Asset Allocation.’ While it is not impossible for an investor to construct such a mix, it helps to have the expertise of a good financial advisor.

There are some hybrid funds that attempt to construct and adjust such a mix, based on market indicators. These are often referred to, as ‘Dynamic (or Tactical) Asset Allocation Funds’. In effect, these use this mix as a means to offer returns that are somewhat comparable to equity funds while attempting to minimize the risks associated with such funds.

These funds are not a substitute for the expert advice of a good financial advisor. Yes, some advisors do use these funds as part of their fund recommendations, but it is primarily through their understanding and execution of asset allocation that they add value for their clients, and not so much through the use of these funds. Nonetheless, in case you want to know more about these funds, the Value Research website offers a comparison that can be accessed here.

Do bear in mind, though, like any other fund, selecting the right Asset Allocation fund requires a thorough understanding of the investment objective and the strategy. Secondly, these funds come in two distinct variants: those that have an automated basis to the equity-debt mix and the adjustments to that, and those that rely on the fund manager to interpret the market indicators and determine the right mix and the subsequent adjustments. If in doubt, stick to the first type (better still, consult an advisor!) Lastly, there are very few of these funds, and fewer still that were actually around in 2008 and 2011 and can, thus, be analyzed for evidence of protecting the downside risk.

Do you really need to invest in mutual funds?

If you fall into one of these three categories of investors, there is a cogent case for you to consider investing in mutual funds.

• You are presently working but will retire at some time in the future.
• You are retired and dependent on the income from your investments.
• You pay high taxes.

Let me elaborate on each of these scenarios.

Presently working, planning to retire:

Barring a miniscule minority, most of us who work, are dependent on the income from our profession. When we retire from our profession, we will be fully dependent on the income that we can passively generate from our investments. Whether we realize it or not, a key purpose of our working life is to acquire adequate wealth to passively generate the income we desire, post-retirement.

Let’s assume for a moment that one were to retire at the age of 60. If medical science continues to progress the way it has, there is a high chance of living up to the age of 90 or beyond. That means that the wealth that one has at the start of one’s retirement needs to see one through a period of 30 years.

The evidence suggests that for a lot of Indians working today, getting to that level of wealth will need them to earn a return on their current investments that is higher than what bank deposits offer. That limits the choice of investment options to stocks and real estate. Without getting into a debate at this point over which is a better choice, let me suggest that directly investing into both these options requires the kind of expertise which is beyond the capability of most investors. That’s where mutual funds come in. Currently there may be no real estate funds in India but there are a wide variety of equity funds available. Yes, building and nurturing a portfolio of equity funds, too, calls call for some degree of expertise but that is far less than what is called for building and nurturing a portfolio of stocks. Furthermore, there are many more financial advisors who possess and offer the expertise for the former, as compared to those who possess and offer the expertise for the latter.

Retired:

As mentioned earlier, individuals in this stage don’t have the luxury of being able to take much risk on their investments. Coupled with the need for assurance of return, such investors tend to choose debt instruments. These instruments carry one significant limitation: you are stuck with receiving a fixed amount for the entire tenure of the investment.

Why is that a drawback? Our expenses do not remain fixed: these tend to go up with inflation. Retired individuals, thus, need an investment option which can either generate the income they need (after adjusting for inflation), or give them the flexibility to draw upon their investment principal, as and when necessary. Open-end debt funds score on the second count. Combine these with a slice of equity funds, and you have a portfolio that could score on both counts.

The need for tax efficiency

To the extent that our money needs to be in debt instruments, we have the choice to opt for debt instruments like bank deposits, Post Office schemes, bonds, and the PPF, or go for debt funds. For individuals paying higher taxes, PPF and debt funds represent more tax efficient choices. The PPF is unique in that it offers both a tax rebate at the time of investment, and its income is completely tax free. It has two major drawbacks, though. There are restrictions on the amount you can invest, and it is not very liquid.

In this backdrop, open-end debt funds present an interesting alternative. These are highly liquid, and have no restrictions on what you can invest. Unlike other debt instruments, there is no assurance of ‘fixed income.’ There are debt funds, though, which have a high degree of predictability as to the return these will generate.

On tax efficiency, open-end debt funds score lower than the PPF. But relative to any other debt instrument these offer far greater tax efficiency. The tax efficiency comes in two forms: the rate of tax, and the ability to defer paying taxes until we withdraw.

I hope to further expand upon some of these issues in the weeks ahead. Nonetheless, feel free to email me if you have any questions or feedback on this post.