Long term for most means encompassing the complete market/business cycles, i.e. eliminating the risk of mistiming and not getting affected by short-term worries. We generally believe that the economy will do well given enough time, and the stock market will follow suit.
Mitigate the risk of negative returns by holding for long term
Most people are afraid of the volatility associated with equity investing and the risk of negative returns. We are more accustomed to traditional investments like term deposits, where we are assured positive return. However, as most of you would be aware, that returns hardly beats inflation. While equity can deliver negative returns in the short term, long-term returns have been historically in the investor’s favour!
Let us see the probability of generating a negative return as we change our time horizons. We will also see whether equity investments could beat inflation (assumed 5%).
Exhibit 1: Historical Probability (or odds) of beating inflation or positive returns from equity at different time horizons
Graphic: Probability of beating inflation
AgenciesSource: MOAMC, Data from 31 Dec 1980 to 30 July 2022 (42 years of Sensex).
The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.
The table above suggests that as we keep increasing our time horizon, the probability of beating the inflation and generating a positive return increases. We have used the CAGR of different time horizons (e.g. 1 yr, 3 yr … 15 yr) to calculate the numbers shown. If we look at the probability of gain (positive returns) for a seven-year investment horizon, only one observation of negative annualized return over the past 35 years was observed. In 10 and 15 years, there is no finding of any negative return. Similarly, there is only one record of less than inflation returns in a 10-year time horizon over 32 years. In 15 years, the probability of earning less than inflation has been zero historically.
So now, we have some idea about how to think about the long term statistically. Next, let us look at another aspect of why the long-term is preferred.
Mitigate volatility risk by holding for long term
People often keep saying that equity is highly volatile, and they do not like to see their portfolio value oscillating. Markets can indeed be quite volatile in the short term, but as history guides us, it comes out of the stress periods even stronger over the long term.
In the chart below, we see how the CAGR of your portfolio moves as time passes increasingly.
Exhibit 2: CAGR progression over a long-term horizon
Graphic: CAGR Progression
AgenciesSource: MOAMC, Data from 31 Dec 2000 to 30 July 2022 (~22 years of Sensex).
The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.
As the chart above suggests, the CAGR can be pretty volatile in the initial years of your investment. For example, considering an investment in Sensex, it moved between +/- 20% during the first ten years. This oscillation can be pretty high for most investors. However, once sufficient time passes, the portfolio CAGR stabilizes and moves in a narrow range, i.e. +/- 3%. Even global crisis events like GFC and Covid didn’t affect your CAGR much. The answer to how the CAGR stabilizes lies in the marvel of compounding, wherein the initial investments make the bulk of the final corpus and are not affected much by sharp moves afterwards.
Conclusion:
By studying the probability of negative returns and analyzing the CAGR progression over time, we estimate ten years as a minimum, which may qualify for a long-term horizon. Staying invested for the long term helps the investors to reap the full benefits of equity investing. Of course, nobody can predict the future market returns. However, with some simple rules, even if you avoid a few basic mistakes like selling too early, that is the job half done.
(The Author, Mahavir Kaswa, is VP – Research (Passive Fund), MOAMC)