Why stocks are called long term investments?

Last Updated on March 17, 2023

Keep a long-term horizon

This is probably the first thing we talk about before going on to discussing stocks and portfolio management. Why so? Correction in 2018 is the exact reason why advisors always keep talking “Long-term”. There is a lot of evidence that the market tends to do very well over the long term despite the crash and burn on its way. Nifty has given close to 13% CAGR including dividends since inception despite it had crashed 30% plus from its peak thrice in 24 year period, roughly once in 8 years.

The risk of stocks falling off the cliff looms all the time but we can certainly have some risk control based on a valuation of stocks. The chances are high that returns would be lower when valuations are expensive. Also, the probability of abrupt corrections is ‘High’ from expensive valuations. Sensex’s valuation ratio has always been in the range of 17-19x earnings historically.

Surprisingly, this is quite a tight range suggesting that an aggregate investor over the long term captures nothing but the earnings growth of Sensex. Investing at more than 15-20% from this valuation range must be considered risky. It makes sense to move out of stocks partially or not add fresh money. To remove any earnings cyclicality of indices valuation, we calculate our own Nifty @MRP. We value each stock of Nifty and compute the final Nifty fair value.

Nifty currently @10,464 is 10% higher than our Nifty@MRP. Given that long term markets operate in a quite sensible manner, an investor is better off making investment decisions only based on long term prospects. Short term spurts tend to excite investors thereby forgetting long term trajectory. Stock picking is exciting no doubt but we tend to forget the mortality meaning, some losses or blow-ups would occur on the way. This is why they are called a risky asset class.

Let the magic of compounding work for you

This is the primary force behind long term investing is the magic of compounding. If you invest Rs. 100 fixed deposits at 6% and in stocks at 10% CAGR for three years, you would make 19% and 33% respectively. This difference doesn’t look a lot, a mere 70% higher. But do this for 10 years, Rs. 100 give 79% returns but stocks would earn 159%, almost twice.

Over 25 years, stocks would earn three times more than FD returns. Over a long duration, a small percentage difference makes a huge difference in the final corpus. Buffett made $62.7 billion of his $63.3 billion networth after his 50th birthday. $60 billion – nearly 95% – is from after his 60th birthday. This is the exponential effect of compounding in long-term investing.

Initial years may seem very boring but in later years returns tend to grow very fast. We recommend our clients and readers to adopt a long-term investment strategy because one, it’s very predictable and two, it is far more rewarding. Chasing short term high returns or even obsessing over short term bad performance is very counterproductive for long term investment strategy. If stocks have to earn 15% CAGR over the next 10 years and your portfolio is down 25%, you still stand to make a good 12% CAGR over 10 years from here. If you add more money regularly when markets are fairly valued, chances are you can improve this return further.

Make sure your portfolio has the right stocks

Then you don’t need to obsess over short term losses. Say your portfolio has a mediocre Besan Paints, down 30% but a quality stock Asian Paints, not in your portfolio, is down 15%, it’s better to book a loss in the former and move to Asian Paints. Asian Paints can i) help you recover your losses faster and ii) chances are higher it will do well over the longer term. While Besan Paints can stay at those prices for a long since it is a mediocre company.

“Time is the friend of the wonderful company, the enemy of the mediocre.” – Warren Buffett

Success in investing comes by improving your odds by making better choices regularly rather than keep waiting for your existing choice to get right.

Focus your long term goals, avoid constant news flow and own good quality stocks.

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