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Revisiting what long term means in equity investing

How much longer do you need to be invested for long term returns to look reasonable? How long should a long-term portfolio continue for?

Sitting at the end of March 2020, another financial year has gone by.  Growth rates on your long-term portfolio may not be looking promising. You had invested to create wealth and now in the midst of this global health and economic crisis, that wealth got eroded sharply and quickly.

How much longer do you need to be invested for long term returns to look reasonable? How long should a long-term portfolio continue?

Defining long term

All investing activity can be either short term or long term. You can make returns too both in the short or the long term. For fixed-income assets, since returns are defined, short or long term depends solely on your choice of a pre-defined time period; your return outcome is pre-determined and not influenced by this choice. 

In case of growth assets like equity, where you can compound your returns, rather than look forward to a fixed, defined pay-out, the length of time you remain invested does play a role in the final return outcome. 

Long term ideally is more than a few years. In equity investing, long term technically should coincide with an entire business or economic cycle from boom to bust. In terms of years, this can vary and be confusing for most investors. Hence, it is simply defined in terms of calendar years and different investors will have a different long-term threshold.  

For an investor there is no defined long term, it could be 5,7,10 or 15 years depending on their own goal or objective. What can be said for sure is that long term investing for individuals spans many years. 

An asset is defined as a long term one when its ability to generate a return at a consistent pace continues for many years. For example, a long-term bond has an interest coupon spanning 10, 20, 30 years. A long-term investment in equity stocks means buying shares or investing in equity mutual funds and holding for many years because you expect the underlying businesses to continue generating profits and remain cash flow positive for many years, thus, reflecting in stock price and the resulting NAV trends. 

Short term volatility versus long term return

In the short term, a few weeks or months, equity returns can be very uncertain and volatile. This means you may see your gains moving up or down in short spans of time. Let’s say, your portfolio consists of one equity mutual fund, held for 5 years. Assume you invested at Rs 100 and today it's worth Rs 200. 

This is an annualised return of 14.8% over 5 years. Now if on day 1 of year 6, the mutual fund’s NAV falls 10% and another 10% over the next month, your 10-year return is likely to be down to 9.8% (all other things remaining the same). 

Now let’s say that the fall in price was due to external macro-economic concerns and after a month of price fall, it jumps back up 25% as investors realise that the underlying companies are going to continue growing earnings as before. Your accumulated portfolio value is now back to Rs 200. This is the short-term volatility that comes with risk assets like equity.

History in relation to equity tells us that the long term trend is established only after 5-7 years. 

If the underlying companies will continue to operate and generate profits and positive cash flow going ahead, despite a few quarters of setback, then holding is the better choice. The price volatility will smoothen out over a period of a few years in line with the earnings growth of the company. 

History in relation to equity tells us that the long term trend is established only after 5-7 years. 

Data shows that since the year 2000, about 30% of the time the 10-year return has fallen below 10% and below 8% about 25%th of the time. The same data shows, if you remain invested for 15 years, there is a 90% chance that you will earn at least 10% annualised return for your long-term investment. 

If you find yourself in the unlucky period where returns are low, you have to stretch your investment horizon a little more so you can be part of the recovery and get closer to your expected long-term return. 

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