The most common question Investment Managers get are “Is this a good time to enter equity markets?” and “ where do you see the markets headed from here?”.
- The first question a very dangerous question to ask someone whose fees is linked to the Capital Invested with them. “You never ask a barber if you need a haircut”
- The second question is akin to the Holy Grail. People keep searching for answers. Truth be told, no one knows what the market will do in the short term.
So how do you decide if you should deploy more Capital in Equity markets at any point in time?
I would propose answering the above question by answering three sub questions
- What is your Investment time horizon ? 1 month, 1 year, 3 year, 10 years ? What game are you playing – T20/test match?
- What is your risk tolerance – willingness to bear notional losses and not exit an Investment prematurely?
- What is the current market valuation vs Long term averages (available via a simple google search or in most business newspapers)
What is your Investment time horizon ?
- Risk of capital loss is inversely related with time
- A long term govt. bond is a risk free instrument if held to maturity. However, if one is compelled to sell the bond in 1 month, and interest rates moved strongly higher in the interim period, it carries a risk of capital loss.
- Using historical performance, probability of Capital Loss if one is invested in Equities in India is 50% if one’s time duration is 1 day, 25% if one year, 10% over 3 years and ~1% over 7 years. Equities of well-run companies become less risky over time as the “risk” of a multiple decline is negated by the positive compounding impact of earnings growth (see more on this below)
What is your risk taking tolerance – willingness to bear notional losses and not exit an Investment prematurely?
- Many Investment Managers have high tolerance for risk. They may therefore counsel a very high exposure to Equities – all in your best interest, but perhaps forgetting that we are all wired differently.
- It is hence your responsibility to understand your own tolerance to witness portfolio markdowns and decide what share of your Assets will be in Equities and within Equities, probe your manager on the risk return trade-offs implicit in the approach followed by them. You may underestimate the losses that could be incurred on a high risk portfolio (high debt burden, poor cash flow)
What is the current market valuation vs Long term averages?
- Equity prices are essentially the multiplication of earnings and the valuation multiple (the price paid for the earnings)
- Your future returns will also be dependent on the change of the valuation multiple between when you entered and when you exited. Multiple depends on the quality and growth of a company but also varies significantly with sentiment towards a security and equity markets – and can change quickly.
- Entering the market when multiples are significantly above historical norms requires much longer time horizons and higher tolerance for notional capital losses
- If you do not have a 3 year time horizon where you will not be emotionally impacted if faced with notional losses, you should not participate in Equity markets.
- If you do have a perspective is 3 years, but the valuations multiples are much higher than long term averages, as at present, be cautious. You are better off deploying Capital over time rather than in one go. A systematic investment plan will work best.
- If your perspective is 10 years, and even if the valuation multiples are against you, as at present, you can still invest now but give your manager time to build the portfolio rather than get edgy if he is not fully invested. Over 10 years, the entry multiple has lower impact as earnings growth dominates returns
- Make alignment on “Investment goals and timelines” the starting point of your discussions with your Investment Manager