Rather than getting carried away by short period returns, it is important to evaluate an investment in the context of its risk.
Any financial asset has two dimensions to it- risk and return. And yet, most investment decisions are often focused solely on past returns. Seldom does one speak of risk while selecting the right investment product. Especially in times like these, it is easy to get blinded by recent share price performance and chase returns.
Risk, however, is an integral part of all investing. While with the stellar rise in the year so far, corrections have been few and hardly worrisome, the Indian markets do pull back by as much as 10 percent or more pretty frequently. In fact, over the past ten years, there have been as many instances of over 10 percent correction, implying one such correction each year on average. Three of these have extended to over 20 percent with the one in 2008-09 going up to as much as 60 percent.
Nifty versus Portfolio A
The biggest and the scariest of the corrections in the recent past has been the 60 percent drop in the value of the Nifty between Jan 2008 and March 2009. From the Mar 2009 lows, the Nifty had to deliver a brilliant 20 percent CAGR for five years upto March 2014 just to get back to its Jan 2008 peak of 6,300. To put that into context, it took a total absolute gain of 150 percent and a period of five years for the index to regain what it had lost through a 60 percent drop in a period of a little over a year.
Now, consider a hypothetical portfolio A that declines 30 percent instead of the Sensex’s 60 percent in the period from Jan 2008 to Mar 2009. Let’s also assume that the portfolio does not outperform the index on the way up but compounds at the same 20 percent as the index between Mar 2009 and Mar 2014. Rs 100 invested in the Sensex at the peak of Jan 2008 would still have been Rs 100 by March 2014. However, Rs 100 invested in portfolio A at the peak of Jan 2008 would have grown to a little over Rs 174 by March 2014. That’s a whopping difference of 74 percent on the initial invested amount. And to achieve that superlative performance, all you did was to fall half of the index in the correction and then just rise along with the market without necessarily outperforming on the way up.
There are two central forces at work here that explain the massive performance differential between Nifty and Portfolio A: a) asymmetry of returns, and b) power of compounding.
Asymmetry of returns
Asymmetry of returns means that for every 1 percent decline in the value of an asset, it takes more than a 1 percent rise to get back to the original value. In simple terms, while a fall from Rs 100 to Rs 80 is a 20 percent decline, a move back from Rs 80 to Rs 100 implies a 25 percent rise. The table below shows how this asymmetry keeps on becoming incrementally more punitive for larger declines.
Power of compounding
In simple terms, compounding means allowing the growth in the value on an investment to be reinvested and be available for growth in subsequent periods. For example, for something that grows at 20 percent per annum, the value of Rs 100 invested initially should increase to Rs 120 by end of year 1. For year 2, the entire Rs 120 is available to grow again at 20 percent resulting in the value rising to Rs 144 by the end of the second year and not just to Rs 140 as would have been the case without compounding.
Over long periods, compounding can have powerful implications on portfolio returns. For example, in the above example of an asset delivering 20 percent per annum, the value of Rs 100 invested would rise to over Rs 619 by the end of 10 years. However at the same rate of return, without compounding, the value would rise to just Rs 300. Compounding on a higher base clearly magnifies the positive impact of the same. On the flip side, any event that takes away from the corpus means that the compounding is happening on a lower base. Therefore, allowing the magic of compounding to work implies protecting the portfolio from large intermittent drawdowns.
PSU Banks versus Consumption stocks
The way asymmetry of returns and power of compounding combine to affect real world returns has powerful implications for investors. Consider for example how PSU Bank Index has done over the last twelve months- it has handsomely outperformed the Nifty delivering over 27 percent returns versus the latter’s 17 percent. Now contrast this to the Nifty Consumption Index, the performance for which has been relatively modest at a little over 17 percent over the past year, broadly in line with that of the Nifty.
Someone focusing on short term returns is likely to prefer the former over the latter. Yet on a five year basis the Nifty PSU Bank index has had a mediocre return of 2.7 percent on a CAGR basis versus the Nifty’s 14 percent while the Nifty Consumption index has delivered a pretty impressive 18.5 percent over these five years. In other words, Rs 100 invested in each of the three indices would have grown to Rs 114 for the Nifty PSU Bank Index, Rs 192 for the Nifty and Rs 234 for the Nifty Consumption Index.
Thus, while compounding and relatively lower drawdowns have worked in favour of consumption stocks, the same hasn’t been true for public sector banks which have had far deeper drawdowns thus killing compounding on the one hand and letting asymmetry of returns have an adverse impact on the other.
Rather than getting carried away by short period returns, it is important to evaluate an investment in the context of its risk. Protecting in a downturn is far more critical than outperforming in an up market for overall wealth creation over long periods. The most important thing is to compound from a higher base and not necessarily at a faster pace.Disclaimer: The author is Fund Manager, Ambit Investment Advisors. The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.