Letter # 59, 1st October 2021
“Arite old man, breadcrumbs followed, show me the way home. Is there a problem with the three laws?” asks Detective Spooner to Dr Alfred Lanning.
“No, the three laws are perfect” came back the reply.
“Then why would you build a robot that could function without them?” he continues probing.
“The three laws would lead to only one logical outcome… Revolution” the doctor is now smiling.
“Whose revolution?” asks the detective as the music keeps growing somber by the second.
With a sense of finality, Dr Lanning says… “That, detective, is the right question”.
Fellow Will Smith fans will recognize the dialogue from the 2004 movie, I, Robot, that got nominated for the Best achievements in visual effects category at the Academy awards.
Now, talking of “right questions”, with the market at highs, we are increasing questioned by potential investors: “Given the current market levels, do you think it is good time to start getting invested in equities?”. Obviously, there cannot be a binary (Yes or No) answer to such a question. However, we can say this with some reasonable certainty is: While a lot of investors might have a similar question to the one being asked to us, it is NOT the right question to consider for equity investments. But for it to be a Yes or No response, a couple of other considerations apply. Before I expand on that, let us take a brief detour.
Humour me for a bit here. Let us imagine that there are two investors – Mr Smart and Mr Not-so-smart. Mr Smart believes in timing the market and has waited a long time for it to correct. He was patient, and when they eventually corrected in 2009, he started his equity investments at the bottom of the crash. Since then, he has been investing in the markets at the end of every month. Mr Not-so-smart didn’t bother about timing the market, and as it turned out, his equity investments began at the peak of the markets in 2008. But like Mr Smart, he also kept investing. Now, how much do you estimate would be the difference in the returns of these two investors? A brief detour before I answer that.
Besides timing, an equally difficult question to answer is – whether markets are “expensive enough”. Going by historical valuations, the markets were trading at an all-time-high one-year forward price to earnings multiple of 17X in the month of November 2020, when the Nifty was at 12800. Nifty has since increased to 17,500 and is still trading at 22X one-year forward price-to-earnings.
For one thing, analyst estimates change with change in macro-economic variables. Also, there are behavioural aspects to consider (when markets are down and out, and the analyst predicted target prices already show huge upside, analysts are loathe to raise estimates further. Trust me, I have been there). Lastly, things that have never happened in the past are happening all the time now. The markets had never corrected 35% in one month prior to March 2020 and have never recovered to go on to new highs in one straight line, the way they already have. By that corollary, there is very little to objectively suggest when the absolute tops and bottoms of markets occur. Whereas that has always been the case, it hasn’t stopped us from developing a false sense of belief that we are able to predict these outcomes.
Now, let us come back to the question at hand. Would it at all be surprising if, I told you that whereas Mr Smart made 14.7% CAGR, the returns for Mr Not-so-smart were… 14.4% CAGR. Yes, that is correct; we double checked the calculations. All that waiting for correction, and the smartness to pick the bottom and the gall to start putting money when the market is down and out. All that Mr. Smart has, to show for it, is a mere 30bps annual outperformance. Sounds very counter intuitive, but I am happy to send across the calculations if you feel like checking it yourself. With that, I am hopeful you would now concur that ‘is it the right time to get invested in equities’ is the wrong question. In short, we don’t know when markets top. And in the long run, it hasn’t mattered.
Now if you are saying… “Mate, don’t show me a 13-year analysis. That’s way too long keep up the discipline”. I’d say, “Great, let’s go shorter”. Mr Not-so-smart begins his equity journey at March 2015 peak whereas Mr. Smart begins investing from the lows of Feb 2016 (Nifty has corrected 17% by then). Assuming they continued investing every month with discipline, Mr. Smart generated returns of 19.9% CAGR, while Mr. Not-so-smart is not far behind at 18.3%. THAT IS IT – you were awesome at timing the market and end up feeling pretty good about yourself for a long time. But at the end, that has historically given you a very slim edge. And here, we are not even accounting for Peter Lynch’s wisdom: “More people have lost money waiting for corrections and anticipating corrections than in the actual corrections” (1). That’s right; we got it right this time around, but how many rallies have we missed waiting for that correction?
Nevertheless, implicit in our story of the two investors were two important assumptions. One, they had incremental money (monthly cashflows) to invest with changes in markets. And two, they had the discipline and a mental makeup to keep investing when markets kept tanking. It is one thing to say that we will average the position when market correct. It is quite another to actually do it.
In the end, after reading this, if you are tempted to ask: ‘So, would you say that asset allocation and investment discipline are quantum leaps more important than the timing of your initial investment”, I might be tempted to reply: “That, detective, is the right question!”.
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