How long is 'Long Term' in Equity?

For someone running the last 100 meters of a 42 Km marathon, one sec can seem to be quite a time. On the other hand, to change a simple habit in your life, a decade may seem quite small. Long Term, therefore, is a relative term in life. But it is not so in equity investments. Whether it is mutual funds or stocks, we can define Long Term quite precisely, clearly and objectively - with logical data points.

Let us see how.

'Being Dead' as an Investment Strategy

Fidelity Investments recently conducted a study in the US to find out what kind of investments provided the best returns. 
The results were startling for anyone who feels is a smart investor. The study revealed that the highest returns were from investors who had completely forgotten about their investment for years, or even decades. 
A good proportion of these investors who were enjoying amazing returns, had actually died a long time ago. The study, therefore, concluded that the most profitable strategy may be to do exactly what a dead person would do - which is nothing.

Why should we define 'Long Term'?

A long term investment is often associated with lesser risk. We just understood from the above study that the longer the term, the lesser the risk - since volatility is averaged out over a period of time.

To augment our statement, just have a look at the last 5 year returns of BSE Sensex:

9% , 42% , -9% , 16% & 10%

The overall annual returns stand at 13%

Now, 13% is a fabulous annual return on your investment - but the variability (volatility) is high. During any short period, you could face poor returns - or even losses (as in Year 3). These poor returns are (over)compensated by a great occasional phase (as in Year 2). As you increase the term, risk will keep reducing. But how long should we keep increasing the Term of investment? For sure, we do not want to die just trying to get good returns. We want to get the returns and use them too - in this life span. Isn't the purpose of an investment to get the returns and use the money as well as the returns arising from it? What use is the money if it just keeps growing and you die of old age? The end purpose of money and investments was always to spend it optimally, so as to facilitate happiness in our life.

Therefore, to strike a balance, we must define a Long Term investment tenure where we have a fairly reduced risk and we can also use the investment and the returns for the purpose it was intended to. Thus, we should be able to precisely answer the question, "How long is long term in Equity?"

How does our Law define 'Long Term'?

Tax Laws are often quite strange, to say the least. Indian IT Act defines Long Term on equity investments after a period of 1 year (12 months). So, does that mean that any equity investment done for more than a year is truly long term and therefore, relatively quite safe?

Not really !

Ironically, on the other hand, any investment done in debt based funds are considered as long term from a taxation perspective only if you stay invested for at least 3 years. So, are we saying that debt investments are more risky as compared to equity investments - and therefore need a longer duration to average out the risk? 

It is actually the reverse. Debt based investments are less volatile and therefore less risky as compared to Equity investments.

So, we cannot go by the definition of tax laws to define the right tenure of any Long Term Investments.

Defining 'Long Term' logically

If you analyse the data for a typical mutual fund with a multi decade history over all the possible 1 year periods, you will find that:

a) Maximum returns are 160% (best 1 year return ever)

b) Minimum returns are -57% (worst 1 year return ever)

If you analyse the data for a typical fund with a multi decade history over all the possible 2 year periods, you will find that:

a) Maximum returns are 82% (Annualised best return ever - over 2 years period)

b) Minimum returns are -34% (Annualised worst return ever - over 2 years period)

If you analyse the data for a typical fund with a multi decade history over all the possible 3 year periods, you will find that:

a) Maximum returns are 63% (Annualised best return ever - over 3 years period)

b) Minimum returns are -18% (Annualised worst return ever - over 3 years period)

If you analyse the data for a typical fund with a multi decade history over all the possible 4 year periods, you will find that:

a) Maximum returns are 59% (Annualised best return ever - over 4 years period)

b) Minimum returns are -8% (Annualised worst return ever - over 4 years period)

If you analyse the data for a typical fund with a multi decade history over all the possible 5 year periods, you will find that:

a) Maximum returns are 54% (Annualised best return ever - over 5 years period)

b) Minimum returns are 4% (Annualised worst return ever - over 5 years period)

This means that the minimum annualised returns you could have made annually if you would have invested in the worst possible fund would have been 4%. 

Do not go by the dwarf-ness of 4% CAGR. Try and understand the significance of this statement. 

Here is the crux. There was no feasible way that you could have made any loss in equity market if you would have stayed invested for 5 years - since your returns were going to be between 4% and 54%.

Let us just go one step ahead.

If you analyse the data for a typical fund with a multi decade history over all the possible 10 year periods, you will find that:

a) Maximum returns are 30% (Annualised best return ever - over 10 years period)

b) Minimum returns are 13% (Annualised worst return ever - over 10 years period)

Wow !! A worst case annual returns of 13% !!

What else you want equity investments to deliver to you? Of course, that is if you stay invested for 10 years.

The above statistics clearly puts the minimum term of investment to be 5 years and the optimum term of investment in equity to be somewhere between 5 and 10 years i.e. 7 years and above. 

7+ years is an investment term wherein you get good enough returns with significantly lesser risk.

Therefore, in equity investments - long term is not a vague term. 

It is 7 years+ investment horizon - also validated by 7 year equity cycles.

Cheers

Manoj Arora

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