Equity returns – more common on paper than in real lives..
In the last 5 years, the Sensex has given decent returns of around 82% which works out to a compounded annual return of 13% every year.
In fact, most of the diversified equity mutual funds have better returns than the Sensex, especially the mid cap funds.
But somehow in real life, we rarely find people who have actually benefited from the equity rally of the last 5 years.
Unlike real estate, where each and every neighbor has a “I-bought-this -land-and-it-multiplied-so-much” story, the stories of huge returns in equities while is true on paper is very rare to see in actual portfolios.
What can be the reason?
As all of us know, equities are an extremely volatile asset class in the short run, with temporary losses historically going as high as negative 56% (2008 when the financial crisis happened).
While this temporary loss looks easy on paper, in reality it is emotionally very difficult to view losses in our hard earned money even if it is expected to be short term (the other issue being you never know how long is the short term).
This “emotionally difficult” part unfortunately is very difficult to quantify.
Thus majority of the times while investing in equities, we only see the past returns (easily available and vivid) and conveniently ignore the “emotional stress” part (cannot be seen, only felt).
So, how do we get a sense of this “emotional difficulty” part??
Dan Kahneman to the rescue..
Thankfully for us, the gurus of behavioral economics, Daniel Kahneman and Amos Tversky have done several experiments to understand how we humans psychologically react to losses vis-a-vis gains.
Their key finding was that:
- Human beings feel the psychological and emotional impact of a loss more than that of a gain
- The estimate is that we feel the impact of the pain twice as much as that of the gain
- This is also called as loss aversion
Source: Franklin Templeton
Now, that’s pretty interesting stuff – Emotional pain from loss is twice that of a similar gain
Let us see if we can use this to evaluate the “emotional stress” of holding on to Sensex.
Emotional Returns of Sensex
The mistake that most of us make when we see the statistics that Sensex gave a return of 82% in the last 5 years is the assumption that we will buy, forget and one fine day we will wake up after 5 years and voila – 82% returns handed to us on a platter!!
Reality is that we keep monitoring our portfolios very frequently. Some do it every month, some every week and some even every day.
Now every time we monitor the Sensex value over these short time periods, we inevitably witness negative return periods and along with it the anxiety of what if this extends and becomes permanent.
And to make things worse, as per the loss aversion theory, these negative return periods are twice as painful as the actual returns. Eg a 5% loss is twice more stressful (i.e like a loss of 10%) while a 5% gain is only as emotionally uplifting as a 5% gain.
While not very scientific, however to get a crude sense of how the returns would feel from an emotional point of view, let us calculate what I call the “emotional return” index (don’t google it..I just made it up)
Here is how I calculate it..
Every monitoring period (eg 1Year ,6 months, 3 months etc) where there is a negative return we will assume twice of it (as per loss aversion theory) and every monitoring period when markets are up we will consider the same gain.
So for eg if we are looking at monthly monitoring, if in Jan-17 my returns are down by 10%, then I will assume it as 2*10%=20%. If it is up by 10% then I will assume it as the same 10%.
Based on this method, for different monitoring periods, the Sensex has been simulated over the last 5 years.
Now let us see how for the same 5 year returns, investors with different monitoring frequency would have emotionally experienced drastically different anxiety levels.
(for the purists out there, the numbers are just approximations to visualize and appreciate the emotional stress involved and by no means is of any serious mathematical validity)
While the Sensex in the last 5 years, actually went up by 82% from 17,430 to 31,730, for an investor who had monitored it every day, emotionally it would have actually felt like the Sensex went down -96% to 655!
As seen from the table, while the on-the-paper return of the Sensex remains 82% in the last 5 years, the emotional experience of investors in getting those returns would be vastly different based on how frequently they monitored their portfolios.
Takeaway: The lesser you monitor the portfolio, the better your experience
So it is easy to say invest in equities for the long term, but the real test is whether we will be able to withstand the emotional stress in the intermediary periods and hang on to equities.
In a world, where portfolio updates are instant and get tracked in your phones, each and every minute, it’s far easier said than done.
So for people entering into equities for the first time, while we know the perils of frequent monitoring, given your anxieties (which is natural given you are entering for the first time), its very difficult for you not to monitor your portfolios frequently in the initial days.
The only choice is to brace yourselves for the emotional roller coaster and while the actual returns might be good over the long run, emotionally it will always “feel” a lot more draining and less exciting.
As you get more experienced, one of the best ways to try attempting at being a long term investor is to stop monitoring your portfolios frequently. I have personally tried this and trust me it makes a huge difference in your ability to hang on.
Once you are past your panicky first time investor phase, you can gradually look at monitoring every quarter and gradually improve to once in 6 months, 1 year etc
And yeah, as always Happy Investing 🙂
P.S: All this long term thinking, is assuming you have done your work and have picked good fund managers or businesses:)
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