There is a story making rounds on the internet of a person from a small village in India, who invested his inheritance of Rs.10000 to purchase shares of a prominent Indian IT company, Wipro, in 1980. He has held on to his investments all these years and now his initial investment of a meager Rs. 10000 has grown to over Rs. 578 crores; taking into account capital appreciation and dividends received. This story might seem too good to be true, but such extraordinary returns are certainly possible when one invests in equities.
I have been brought up in a family where most individuals considered equity investing to be nothing more than speculation and gambling. Over the years, I have realized that for middle-class individuals like me, equity investing provides a legitimate avenue for long term wealth generation, leading to early retirement and an escape from the weekly 9-5 grind in the corporate world.
Historically, equities or stocks have far outperformed other asset classes in the long-run. However, retail investors tend to massively underperform in the market.
One lakh taka invested in the S&P 500 stock index in the USA in 1987 would have grown to over twelve lakh taka in 2019. No other asset class in the world provides such outsized returns. So, why do retail investors perform so poorly when investing in equities? My observations are that investors fail to cultivate characteristics and capabilities prevalent in all world-class investors;
1. Contrarian attitude: All good investors have the ability to think outside the box and hold opinions on investments that differ from the majority of people.
2. Able to value and identify good quality companies: The ability to analyze financial statements and understand key accounting ratios is critical to good investing performance. A person who is time-constrained should take the mutual fund route to enjoy the returns offered through equity investing.
3. Conviction and humility: Investors should have the conviction to hold on to their investments when stock prices fall by 50% and the humility to admit that they have been wrong in their choice of investments and sell their investments at a loss.
4. Patience: This is perhaps the most important characteristic. Economic recessions usually occur once every decade. Pandemics such as the Spanish Flu and Coronavirus are rare, but not unheard of. However, the point to note is, through all the wars, calamities and recessions, the world economy, based on data from the last 120 years, always bounces back stronger than ever. Investing in equities is akin to a roller coaster ride. The returns are highly volatile, but in the long run, the investor never loses money. A good investor deploys their cash during recessions and buys up good quality blue-chip stocks on sale. An investor must have the patience to stick to their investment for years, or even decades, even when the consensus in the market disagrees with his opinions.
5. Understand compounding: Good investments grow exponentially in the long run through the magic of compounding, a phenomenon which good investors know and utilize. Grameenphone, ever since its listing, has given dividends far in excess of its IPO price and now trades at a price several times higher than what the initial investors paid for the share.
6. Think of shares as ownership in a company and not pieces of paper: When you buy a share, you are a part-owner of a company. Good investors think and behave as the owners of the company. This attitude will prevent you from frequently buying and selling shares.
Now that you are cognizant on the characteristics and abilities required to be a successful investor, how should one invest during such uncertain times?
1. Significantly increase allocation in equities: Now is the time to invest in equities. Warren Buffet has said that "Investors should be greedy when others are fearful, and fearful when others are greedy". The DSE broad index has fallen from an all-time low of 6336 in November of 2017 to 4008 recently. This is a massive correction in any sense of the word. Most investors have liquidated their investments and sworn off investing in the current market. Good investors rejoice during such times and pick up good quality shares available at bargain prices. Retail investors usually buy shares when the market is booming and run for the hills when the market tanks. This does not mean that the investors will stop investing in other asset classes and go all-in on equities. Good invest returns rely on balanced portfolio construction, consisting of allocations in bonds, real estate, equities etc.
2. Stop looking at your portfolio: Look at your portfolio once every month or, even better, once a quarter. This will prevent investors from making irrational decisions when looking at the unrealized paper losses on their portfolio
3. Learn to accept big declines in your portfolio: Your portfolio will decline, learn to accept it. You might be looking at upwards of 50% loss in your portfolio in a recession. Be patient in the knowledge that if you have invested in good companies, your investments will grow manifolds once the market recovers. Time is a friend of good companies and an enemy of poor companies. Get used to stock market bubbles and the subsequent bursts. Stock market bubbles, such as the ones in 1996 and 2010, will occur again in the future, followed by massive declines in equity value. But, take heart, returns will normalize again.
4. Avoid financial talk shows like a plague: Nothing good will come off listening to people forecasting and analyzing the future of the stock market. Nobody can predict the market in the long run, except the Almighty. Most of the information being spewed in the financial channels are noise, which will prevent you from achieving your financial goals.
5. Stop trading and sit tight: Trading is injurious to your financial health. Frequent trading in stocks will erode your returns and benefit only the brokerage houses who get rich from commissions generated from your trades. Be wary of traders who encourage you to buy into junk shares and the latest trends. They have an incentive to generate more commissions for their firms and no incentive to ensure your financial well-being.
6. Invest only in good companies: Invest in good companies. What do I mean by "good" companies? Good companies are organizations with a long track record of growth, dividend history and good quality management. Invest in companies where the management is trustworthy, the company is growing at a sustainable pace and earning returns in excess of its weighted average cost of capital. Good companies have a high return of equity, return on capital invested and ample free cash flow.
Good equity investing is boring and relies on the utilization of frameworks and strategies I have outlined above. There are other manners in which a person can successfully invest in equities but I have outlined an approach to investing that has worked for me.
Saihad Shahid Rahman is a faculty in The Business Administration Department of American International University- Bangladesh (AIUB)