Why Do We Invest? Where Do We Invest? Why Most Fail at Investing?
The Motivation
Why do we invest?
Our investment goal is to achieve superior returns. However, mere superior return isn’t enough. Two caveats make the superior return purposeful: durability and sustainability.
We don’t want our investments to make superior gains in one year and then give up all those gains over the subsequent years. Therefore, the gains must be durable. Additionally, we don’t want our investment to make superior returns in one year and then give mediocre returns over the subsequent years. Hence, the superior return must be sustainable.
So, how do we increase our chances of achieving superior returns that are durable and sustainable? I believe there are two facets of a stock that can increase our odds here: one is the source of earnings growth, and the other is the competitive position.
Even though in the near term, many factors influence a stock’s price, it is empirically observed that, over the long term, earnings have the greatest (dominant) influence on a stock’s price movement. In simple terms, price follows earnings in the long term. We can infer from this that, a durable and sustainable earnings growth would result in a durable and sustainable stock price performance. However, only earnings growth that originates from a firm’s principal operating activities is durable and sustainable. Hence, confirming that a firm’s earnings growth emanates from its operating activities increases the odds of achieving a durable and sustainable stock return.
The other facet is the firm’s competitive position. An industry with high growth and profitability will naturally attract new firms into the industry. This will increase the competitive intensity within the industry which shall result in lower growth and profitability for both incumbents and new entrants alike.
However, a firm with some unique quality (or qualities) that helps it stand apart from its competitors – competitive advantage – is empowered to withstand the adverse effects of increased industry competition. Such firms are empirically observed to maintain their growth and profitability despite the increased competition. Hence, such firms – due to their strong competitive position – can achieve durable and sustainable earnings growth, and consequently, exhibit superior stock price performance that is durable and sustainable.
Normally, when we are asked about our investment objective, for most of us, the instantaneous answer is achieving superior returns. However, I believe a more concise definition of the objective of investing is preserving, and preferably increasing, the purchasing power of your capital.
The purchasing power of your capital falls over time due to the general rise in prices of goods and services. In India, the Inflation rate has averaged 6.83 percent annually over the past 30 years. If your investment fails to match or exceed the inflation rate during the invested period, it means your capital has lost its purchasing power. Conversely, the purchasing power has been enhanced if the return exceeds the inflation rate.
Superior means better or higher than others. So, if equities returned 5 percent during a period when other major asset classes gave negative returns, equities had delivered a superior return. However, if inflation exceeded 5 percent during the period under consideration, then despite a superior return, equities fail to maintain capital’s purchasing power. The point is that for your capital to preserve its purchasing power, the return being superior isn’t enough, the return should at least match the inflation rate.
Fortunately, in India, we have succeeded at that over the past 30 years. Despite a higher average inflation rate (6.83 percent), gold prices rose 9.22 percent annually and Sensex gained 11.38 percent annually over the past 30 years. An investment either in gold or in the stock market would have enhanced the purchasing power of your capital.
We call such return – the investment return after accounting for inflation – the ‘real return’. For Gold and Sensex, over the past 30 years, the real returns were 2.39 percent and 4.55 percent, respectively. A real return greater than zero means your investment has succeeded in enhancing the purchasing power of your capital.
The inference from the above discussion is that for an investment to be considered successful, its return should satisfy four conditions: 1) it should be superior – the return must be better than return from other asset classes in the same period; 2) it should be durable – the gains achieved in one year shouldn’t be given up over subsequent years; 3) it should be sustainable – the (superior) return must be repeated over years; and 4) it should be real – the purchasing power of capital should be maintained or enhanced.
The Niche
Where do we invest?
The value of specialisation is a long apparent principle in every field. With the right knowledge, attitude, and effort, you can succeed at anything, but, not at everything. I believe this principle applies to investing too, profoundly. You need to choose an asset class through which you intend to build wealth.
Whatever type of asset class you may choose – bonds, equities, real estate, commodities, gold – it must closely align with your temperament. It is only you who can find an answer to this question – through trial and error – through experience. The only sure-shot way to learn the principles of investing, and the asset class that suits you, is by doing it.
Once you have deciphered the asset class that closely matches your temperament, the next job is remaining steadfast in your chosen path. A person who dabbles in several asset classes… at the same time… to build wealth… will always stay disgruntled.
I found my niche three years into my investing journey. It is investing in – listed, low market capitalization stocks – with strong fundamentals and high growth prospects – at reasonable valuation; and staying invested as long as the fundamentals and prospects remain promising.
The Impediment
Why Most Fail at Investing?
I assume most of you are familiar with the concept of ‘compounding’ in finance. If you are, you can skip to the next paragraph; here is a brief intro for others. In simple terms, compounding means earning a return on your original capital and on the returns on the original capital you have received previously. For example, suppose you invest ₹10,000 at a 10 percent annual interest. In that case, you receive ₹1,000 as interest in the first year but receive ₹1,100 as interest in the second year: ₹1,000 as interest on the original capital plus ₹100 as interest on the interest received in the first year. The interest received each year will keep increasing as time progresses, and in the above case, the interest received in the tenth year would be ₹2,358, more than double the interest received for the first year.
Compounding is the underlying mechanism of successful investing. Here, the ‘time’ element has the most significant role in determining how much you will benefit from compounding. The greater the time that you give your capital to compound, the greater will be the gains that will accrue to you. So, adults – those aged between 20 – 39 years – are the most privileged when it comes to benefiting from compounding. It is when the majority gets employed and starts to earn, and thus, the earliest possible time to start the investing journey.
However, anecdotally, they are the ones who pay the least attention to investing relative to their other activities. They are more interested in spending than investing. The reason that… they don’t have time for it… because they are busy – with work and kids – seems preposterous… because when it comes to spending activities – movies, eating out, beach visits, vacation trips – somehow, they can make time.
Spending – on wants and desires, not needs – is easy and impulsive but hurts you in the long term. Investing involves curtailing your present spending to enhance your future spending power. However, unlike spending, it requires a certain degree of willpower, self-control, and the ability to delay gratification; and that is where most of us fail.
Those who have ‘time on their side’ are not interested. However, those who have realised the value of investing and the power of compounding… unfortunately, the realisation mostly being a delayed one… don’t have ‘time on their side’—a conundrum you can find, not just in investing, but in many walks of life.
AMN CAPITAL 