Retirement Planning & Long Term Investment Management – Part I

A few days back, I was reading an article in the finance section of a leading newspaper. The article talked about long term investment and retirement planning. It took a good and practical example as follows:

Assume that there is a provision stores in your neighborhood. You visit the shopkeeper and ask him how much will he make or sell in next 1 hour. There is a 99% chance that the shopkeeper will not be able to tell an exact figure because he has no idea or certainty about how many customers will visit his shop and how many of them will buy things and for how much. Then, ask the shopkeeper how much will he make at the end of the day.

The shopkeeper may quote a figure based upon his daily average sales estimate for a season. Now ask him how much will he make in this month or quarter, there is a 99% chance that he will be able to quote a figure with a high level of certainty. At the end of that month or quarter, you will find that his actual predictions are quite accurate.

The article compares this to investments in stocks. It claims that investments in stocks are similar to the situation mentioned above. When you are asked about a short term horizon, like one hour, one day or one week, you will not be sure how your investments will work. There is no certainty that the stocks that you’ve bought will make x amount of returns in this short horizon. However, when you make an investment for long term, it is possible for you to make a forecast and give accurate indications about your investments. The longer the time horizon, the better the investment return and the more certain you can be about your predictions. Hence, for long term investments and retirement planning, you should use investments in stocks as an effective mode of certain returns.

The article claims appear to be genuine and are rightly justified by the example of the shopkeeper which is wisely mentioned in the article. Historical data also proves that stock investment has always outperformed the other forms of investments like bonds, forex, real estate and so on. It is true that a person can make estimates about the business he is running and is completely involved in it. But can a person make predictions about a stock performance even in the long run, especially when the investment is made with a important purpose like retirement planning and pension schemes?

The biggest drawback of the above article is that it is citing the example of a shopkeeper who is involved with his heart and soul in his business. He thinks about it 24 hours a day, manages it to his full potential and knows the dangers of him being thrown out of it by the competitors.

When we do stock selection, are we well equipped and aware of the businesses that the company is into? People always name a few top performing stocks like Infosys, Reliance, ACC, etc. but the fact is that these assumptions are all based on historical performances. Is there any guarantee that the company will continue its past performance even in the future?

Let me quote an example of Wipro that I received in an email forward. When 20 year old Azim Premji was given the ownership of Wipro and he decided to step into the software business, an elderly shareholder of Wipro, aged around 45, questioned him in this way: “Mr. Azim Premji, why don’t you give your majority Wipro stock ownership to someone more experienced who can take better business decisions instead of jumping into your fantasies of computer business and putting investor money at stake?”

The rest is history. Initially a cooking oil company, today majority of revenue for Wipro comes from the computer and software business.

In my previous article Index Fund Investments , I’ve quoted examples of companies like Mukund Iron, Premier Auto, Pieco, Bombay Burmah, etc. which were once a part of Sensex, while today these companies do not exist. Either they were bought over by their competitors, or they went bankrupt, dissolving all the money of investors. Betting on mid-cap or small cap stocks is even more dangerous. If you get a chance to meet an unfortunate shareholder of Global Trust Bank (GTB), ask him how much he lost on his investment and you will know the plight of loosing the money in stock market.

Another assumption the article makes is about the LONG TERM of investment. People always say that equities give better return in the long term. What is exactly meant by long term? We should understand clearly that every term, whether long or medium or short, has a deadline. When we talk about long term retirement planning and investments for the same, the deadline is the month and year when we will be leaving the job and officially we will retire. Have a look at my previous article Do equities give better returns in the long run?. The biggest error we make when we talk about the long term is that we ignore the fact about our investment maturity. As explained with a graph in the previous article, the market went down consistently in the last 3 years of the long term horizon. The result – a 60% loss on the portfolio. How will a retiring person feel, when at the age of 55 (3 years before retirement) he sees his investment at a staggering amount of 50 lakhs, but due to market fluctuations in the next 3 years, he looses 60% of his portfolio value and his investment value comes down to just 20 Lakhs when he is about to retire at the age of 58. In essence, it is very true that the equities give better return in the long run, but we have no idea or certainty about this long run.

Continue to Part II of this article