Thursday, May 17, 2007

Investment Horizon and Returns

Most people who begin to invest in either equities, unit trusts or derivatives don't really have an idea of investment horizon. Neither do they actually have a concrete or realistic target for investment returns. This post will try to tackle some aspects of this decision-making process, and to share my own personal view of my horizon cum returns expectation.

Investment horizon can be defined as the period of time in which you wish to "lock up" your investment. This means that during this period of time, the investment basically stays dormant, either increasing or decreasing in value. This is akin to a fixed deposit where your money is "frozen" with a fixed interest rate until withdrawal. However, for equities, the time period can be anything from a few minutes (for day traders) to a tens of years (value investing). When one puts in a sum of money into a counter, one must be mindful of their investment period, for this has a bearing on their returns. For short-term traders, a few minutes is sufficient as long as they hit their profit % target. For investors, letting their profits run is common, and multi-baggers emerge among the good companies.

This all seems very simple right ? Short-term and long-term isn't exactly rocket science ! The problem surfaces when people turn a short-term trade into a long-term investment, or vice versa. To illustrate, take Mr. X, who plonked down 10 lots of Lottvision today at 65 cents (the peak) with a long-term view to seeing the company's lottery business grow and generate good earnings. However, when there was a massive sell-down to 56 cents, suddenly he panics and turns his long-term ambition into a short-term trade by selling. This is an emotional response which is typical of human psychology, thus Mr. X cannot be faulted for feeling panicky when his shares fell 20%. The trick is in determining, in the first place, why you bought the company and to fix your investment horizon. If these are in place, no amount of fluctuation will cause you to sell low. Volatility gives opportunities for value investors to buy at cheap prices, as there are always people out there who will panic and sell low to YOU.

Another counter-example is a guy called Mr. Y who decides to do momentum trading, or as they call it, going with the flow of the crowd (see my post on "the madness of crowds"). He buys in excitedly at 65 cents (Lottvision again, since this is such a wonderful example of a volatile stock), hoping to flip it quickly at a profit when it hits 70 cents. Let's say, hypothetically, that the share price starts to tank and it never reaches his buy price for the next few weeks. He will then decide to turn into a "long-term" investor, and wait it out. I have seen this happen to older relatives, who have told me horror stories of holding Informatics at 80 cents, BBR at 70 cents and even Van Der Horst at $8 (it's now called Interra Resources and trading at a fraction of $8).

So what's the moral of the story ? I am not saying buy and hold is wrong, but we must make decisions based on objective facts, and not be driven by emotions. Evaluate the company to see if there is any potential, or if its business is just going downhill. This is a key factor in determining whether buy and hold is suitable, or to sell immediately and take a minor loss. After all, money invested in a losing counter is also an opportunity cost.

Most traders will tell you to have a cut-loss strategy of let's say, 10% below your buy price. But how many of us has the mental discipline to stick to it ? From the people I've met, I dare say nealy 99% will just hold through the drop. Thus, in the end, people buy high and sell low.

For investment returns, I see people on forums having extremely unrealistic expectatons ! People always expect to buy something for like, 3 cents, and hope to see it go up to $1, for a 33 bagger ! Let's be realistic, how many companies can grow their earnings by 33x over a period of a few months ? Others will expect sentiment-driven rallies to last forever and keep averaging up, only to end up with negative returns in the end.

A good way to be realistic about returns is to benchmark this against returns from other forms of investments. As far as I know, cash gives the lowest return (less than 1% p.a.), bonds give about 5% on average while equities have been known to average about 11-12% return p.a. over 30 years. Thus, a good figure to expect will be in the range of 10-15% for a long-term horizon. I will not discuss short-term expectations as everyone knows that investment profits/losses can be wildly fluctuating. What I am dicussing is a consistent approach to obtaining returns on your investment.

To conclude, investing with a good margin of safety will give the investor an overall return of 10-15% on average, per year. This is inclusive of dividends as well as capital gains. Investing wisely and not based on sentiment will ensure that your money can only grow in time instead of shrinking. Remember leh, this is YOUR hard-earned money, so use it wisely.

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