Stock market returns beat other investments in the long-term, but the returns are lumpy and volatile. It can take years for equity investments to pay. There are always long periods of drawdown. There is no way to determine the magnitude or duration of a trend in either direction.
How can somebody who is not a dedicated market-watcher cut down the risks and boost returns at the same time? The answer appears to be simple, but it's difficult to implement psychologically:
1) Buy a diversified basket of stocks such as a market index. 2) Hold investments for a long time. 3) Use valuation-based filters to weight market exposure.
To implement this strategy requires patience and faith, rather than vast IQ. The investor must believe that the losses incurred during the inevitable downturns will be less than the gains during uptrends. It is psychologically hard to maintain this attitude in the middle of a long bear market.
Now for some statistics, which validate the advice above. In June 1991, the Sensex was at 1,300 when the New Economic Policy was announced by Finance Minister Manmohan Singh. In March 2013, the Sensex is at about 19,000. That is a CAGR of roughly 13 per cent across almost 22 years and it beats even the artificially-hiked provident fund return by a massive margin.
This 22-year span saw many alternating bull and bear markets. There was a spurt in prices between June 1991-March 1992. The next bull-market was from April 1993 till September 1994. There was a third big bull market in 1999-2000 and the biggest bull market in Indian history started in May 2003 and continued till January 2008. There have been two more bullish periods since, between March 2009-November 2010 and between January 2012-to the current date.
Of course there were corrections within both the bull and bear markets. The bull runs accounted collectively for about 130 months out of the 261 months that have passed since June 1992. Roughly half the time, the market range-traded, or logged losses. Several of the bearish periods have seen drawdowns of between 40-65 per cent.
The 13 per cent CAGR mentioned above is a point-to-point theoretical benchmark. It would be realistic only if somebody had bought once in June 1991 and held until March 2013. A rolling return profile offer more realistic insights into actual risks and rewards.
We may assume, for example, that an investor buys every month and sells each position a year later. That is, he buys in January 2012 and sells in Jan 2013. This is equivalent to a strategy where the investor buys and holds for one year.
Between June 1991-March 2013, the average rolling return comes to about 15 per cent per annum for these one-year rolling "trades". There are 97 losing one-year trades, versus 153 winning one-year trades. The investor saw a positive payoff roughly three times for every two losses.
Similarly, a two-year rolling strategy yields an average annualised average return of 15 per cent. But there are only 82 losing trades to 156 winning trades. A three-year roller yields 16.5 per cent, with 177 wins to 49 losses. A four-year roller yields 17 per cent with 169 gains to 46 losses. A five year roller yields 18.5 per cent with 170 gains to 33 losses.
The trend is clear. The longer the hold, higher the returns and lower the risks. This can be directly compared to recurring deposit schemes. The differential in favour of equity is huge.
Valuation filters help an investor further reduce risks. For example, the average monthly PE of the Sensex is 21, with a median of 18.7 and a standard deviation of 8.3. The median shows that the Sensex traded below 18.7 half the time. There are more high-valuation months (37 months were above PE 29 - 29 is one standard deviation above average) versus low valuation months (17 months were below PE13 - one standard deviation below average).
If an investor buys more when the PE is below 18 and less when the index is above PE30, his returns are further boosted. The number of losing trades also reduces if there are no buys above PE37. Dividend yield has also been ignored above. It adds about 1.4 per cent annually. That is significant, especially if re-invested and compounded.
The statistics indicate that an investor doesn't need to be smart or knowledgeable, so long as he's disciplined and patient. Buy a diversified basket or an index fund for the long-term and use a basic valuation filter. The return: risk ratio will automatically get better without much required in the way of judgement or portfolio monitoring.