Wealth Creation in Stock Markets

Wealth can’t be created just because you want to do so. “Show me the calculations my friend”, you would often ask your advisors. Sounds good! Last month, while I was sitting with one of my friends, the same question cropped up. When asked “do you want my advice or just calculations”, the reply was as expected “I am a long-term investor; advise me on some investment opportunities” and with those lines, the additional conditions were as follows: “Look, I will not invest now, markets are in a bad shape, and we may be in a recession”. Secondly, “the stock must not be of more than 100-200 rupees; I generally do not buy expensive stocks”.

Out of curiosity, I asked, what is the time horizon and purpose of the investment? The answer was “long term, but usually, I believe in booking profits as soon as they appear in my account”. All this reminded me of the typical behavioral issues of investors: With the mental sufferings of loss aversion, speculative instincts, and illusions about markets. This is a story of almost all the investors around. They enter the investment world as long-term investors but in reality want quick bucks. They do not invest but try buying some “lottery tickets”. People find lottery tickets fascinating even though almost all lose money on the lottery tickets.

As a standard reply, I must say: “My friend, you want to create wealth, but wealth can’t be created, just because you want to do so”. You will have to learn the art of discipline, behavioral finance, and of course, a little understanding of financial markets.

Through this article, I am trying to cover some of these issues and will discuss how some unbiased understanding of the financial market with the help of mathematical tools can help an investor generate better results than an average investor.

Where do behavioral issues originate?

One of the exciting functions available in almost all spreadsheet calculators is Future Value, “FV”. Based on certain assumptions and guesstimates about the future, it can easily give you the future value or the corpus required to achieve certain goals. Furthermore, with its variant, Payment, “PMT”, you can estimate the number of periodic investments you need to meet these goals. With these handy calculations and a positive mind, you just start investing, probably through some systematic route or lump sum.

This fundamental and common strategy is good enough and works at its best if the assumptions that informed the calculations turn out to be true. But here is a common catch: the degree of reliability (i.e. mismatch) of these uncertain assumptions for the goals which are probably more certain.

Though we are clear about the fact that all these assumptions are just estimates, we have mostly never questioned the source of these assumptions and questioned what happens if they do not hold true. Have we questioned? If you are an advisor or an investor, the chances are you would care a lot more about the number of investments you are currently making and even more care about odds that you or your client should not lose money. Hence, you go with the mindset (or I call it illusion) that most of these assumptions are common and are the same with all kinds of situations, with all investors, and with some heuristic rules of thumb, and therefore you feel no need to alter or customize them.

So what should we care about when we are investing? What should be our investment strategy? Well, all we need to understand is that these assumptions are not only numbers or guesses (about time horizon and expectations of the rate of returns), but are a semblance of one’s behavior and understanding of the real world. We have to understand that money has no colour and that it is fungible. Any money can be used to meet any goal. The emotional baskets of goals that we create and sometimes lose track of may not always be fruitful.

Understanding markets for wealth creation

There is a famous quote “Markets are always right; it’s our decision which is right or wrong”. This phrase highlights important issues that we need to understand. The issues that we need to understand are the very root cause of market existence and why there should be any extra returns in one asset class (say equities) as opposed to others.

In some good years, the returns are as high as 100% (in equity funds) and in some, for instance, the present year, they are as low as -60%. This data suggests that in shorter periods, the returns tend to fluctuate and may deviate to a large extent but over a long period they normalize and revert to average, known as the law of mean reversion and thus it is highly probable that you will get average returns over the long time periods. If we take the average risk, the more likely outcome will be that we will have a sort of average returns over the longer term.

Wealth creation will have to deal with the problem of market volatility.

However, there might be some periods during which any decisions we take can significantly change our return profile without hindering our risk appetite (though it may appear for some time, and we will discuss this in the later section of this article). The answer to this periodic analysis is in the concept of market efficiency or efficient market hypothesis formulated by Eugene Fama in 1970. Though controversial, the thesis suggests that at any given time, prices fully reflect all available information about a particular market. In efficient markets, market prices adjust everything (including foreseeable future), so no investment pattern is fruitful.

However, EMH does not reject the anomalies in the markets. We have seen the periods of global financial disaster of 2008 and experienced how markets became so inefficient to predict what happened later. If someone was bold enough to invest in 2008, we all know the kind of returns that could have been generated. At the same time, we also often observe the anomalies when the market seems to overreact to positive expectations (small-cap run of 2017).

“What should I do with this efficient market theory”, you might ask. Well, as I use to quote “Markets are always right, it’s our decisions which are right or wrong”. This analysis of market efficiency helps you to make the right decisions and to understand why it is so difficult to beat the market for an average behaviorally charged investor and what is actually required to create wealth out of these efficient markets.

The first step towards wealth creation

The scholars of traditional finance assume that investors are risk-averse and they dislike risk. If I ask someone a question “what is risk?”, the most common answer would be that the “probability of losing my principal is the risk”. This answer is behaviorally correct but not mathematically correct. The technical definition of risk is volatility against the expected returns and not the loss (read more on standard deviation and variance).

The behavioral finance has proved that people are actually not at all risk-averse, they are rather “loss averse” and hence, they do not dislike risk but they dislike loss. In his book, Your Money & Your Brain, Jason Zweig goes through multiple studies and stories to show how our brains react to different forms of the stimulus (mostly gains and losses). The fact is that the financial losses are processed in the same area of the brain that responds to mortal danger (the danger of death). This helps explain why losses hurt so much more than gains feel good. This loss aversion can be a huge issue that needs to be addressed for our long term financial health as it tends to give birth to “disposition effect”, under which we normally book profits earlier than we book losses.

Because of another mental block “representativeness”, people tend to weigh short term returns than weigh long term returns. If in a particular year (remember 2018!), the markets are down by 15%-20%, we start believing that this will continue and forget about the long run; similarly, I have heard people talking about doubling their money in just one year and believing that they can do it forever, again not realizing the long term mean reversion effects.

The first and foremost rule for long term wealth creation is not only understanding the markets but also understanding them without emotions and inculcating a discipline about investing. If I were to ask you: what is a common trait among market tycoons and legends in the field of investing, almost everyone tries to convince me that they have some super network, some super luck, and knowledge. The answer is actually nothing but “discipline”. They believe in long term investing, in not following the herd, and indisciplined investing.

The right strategy

The answer about is what is wrong and what is right is although difficult but somewhat given in traditional finance. While behavioral investing focused on “what it is”, the focus under traditional finance is “what it should be”.

The traditional or the rational approach is not rocket science but objectively estimate the market’s risk and returns to build your expectations. The returns can simply be expected by the long term average returns given by the investment avenue or through various other quantitative models. The risk is measured through standard deviations of those returns (and not the loss). These values can be put into an optimizer tool which will give you the scientifically calculated proportions of these products in your portfolio based on your return expectations and /or the maximum risk you are able to take for your portfolio.

This ability to take risk will be a pure function of the time horizon of your investment (longer the time horizon, higher will be the ability), liquidity requirements and criticality of your goals, your existing net worth, and certainty about your future incomes. A predetermined score should be given to these parameters to come up with a number that will tell you how much risk (or SD times) you can afford with your investment portfolio.

Once you finalize the proportions, you can invest directly, on your own (if you are smart enough in stocks or bond selection), or using the simpler way, you can go the mutual fund way; you can go ahead and give your money to a professional fund manager. But again, you need to understand the nitty-gritty to some extent. If you go to actively managed PMS or mutual funds, supposedly run by competent fund managers and supported by analysts and market makers, they will charge you some fees to cover their costs. In return, they are supposed (but not obligated) to generate for you more returns than the market does. Or in simpler words, “beat the market”.

As an active investor, their performance should be linked with excess returns generated over their benchmark and not with any absolute number, and thus rather than generating the maximum return, the focus of a rational investor is on majorly on those excess returns.

What if I can’t actively do all this stuff?

“I should not invest and stay away”. This could be thought from many of us. The answer is no. You need to adopt a “passive route to investing”. If the intent is to generate market returns, the best instrument is a managed ETF or a low-cost index fund. These funds mimic the return of indices such as Nifty, Sensex, or Nasdaq. They invest in the same constituents of the index with the exact proportion as of their index. The modern finance theory suggests that market portfolios such as Nifty and Sensex are most efficient in the sense that they are relatively lesser volatile than any other portfolio and thus provide the best risk-adjusted returns in all forms of EMH.

In one of his interviews given to Fox Business channel, the great economist and author of the bestseller book “A Random Walk Down the Street” Burton Malkiel argued and endorsed this style of investing. The expenses charged by an index fund or an ETF are way lower (almost nil) than the expenses charged by an actively managed fund (around 2% per annum) and this is a major source of underperformance of the active funds according to Malkiel. Think over it, before investing.

Does timing matter?

It depends on what kind of timing you are looking at. A legend once said, “Be fearful when others are greedy and be greedy when others are fearful”. If I try to guesstimate this fear factor with volatility and chart the volatility adjusted returns of Nifty, I will get the following:

These blue clouds are the volatility adjusted returns of the Nifty along with the one year return of the same (the blue line). We can see that we have touched the extreme kinds of zones just two-three times from 2007 to the current period and that we are around there today as well, (off-course on the downside). We touched these down levels once in 2008-09, then in 2016-17, and in 2020. Now let’s see what happened after that. Nifty rebounded sharply and we saw the returns in the range of 30-40% in the next 2-3 years. “Reversion to the mean is the iron law of the financial markets”. History teaches us that when valuations in the markets are at extremes, a move towards historical norms is likely and recoveries are fast. The extremely high levels we saw in 2010, 2015, 2018 and 2020 were also not sustainable levels, and the rest is history.

Last but not the least

Remember that long term gain can only be created through instruments that get an increase in value with the increase in the overall economic value of the country. Equities can be one of them. The gold, the FDs, and the bond cannot create wealth but can only preserve it from erosion that is caused by inflation. Keep yourself away from wealth destroyers such as high-interest loans, over-limit on credit card purchased, and unnecessary indulgence in luxury goods. Stay healthy and always subscribe to adequate health, auto, and life insurance; they will help you preserve your wealth that can be destroyed by untoward incidents.

But the real thing still remains the same “the discipline” in your investing. You have to invest irrespective of market conditions, irrespective of what is reported in the media, TV channels, and the newspapers. Be disciplined about entry, exits, and rebalancing of your portfolio based upon your changing risk tolerance levels (probably, as you age your goals start coming nearer). Some practitioners follow the market valuation based approaches to rebalance. They increase their equity exposure when the P/E ratios of general markets decline to some long term average and similarly decrease their equity exposure when the P/E ratios of general markets deviate significantly over long term averages. Here is a P/E chart (the blue line) with a standard deviation based upper and lower bounds: