Why it is important to stayed invested in the stock market with a long-term outlook

The stock market may appear daunting at first. As much as there are success stories in the news of the Warren Buffets and the Dhammika Pereras of the world, there are also tragic accounts of loss and hardship.      

In order to understand the stock market, it is important to initially recognize the premise of capitalism. A profit-seeking entrepreneur’s goal is to make a higher rate of return on his/ her equity investment than the rate offered by low risk assets such as government bonds or fixed deposits. In other words, if the per anum fixed deposit rate at a financially prudent bank is 11%, as is currently the case in Sri Lanka, an entrepreneur would seek a return in excess of 11% for the risk that he/she assumes.  

The shareholders of publicly enlisted companies naturally have the same goal. Although companies in the stock market as a group may fail to make a suitable return in the short term, they will make a return in excess of low risk assets in the long run.  

The price appreciation of both the ASPI (a stock market index in Sri Lanka) and the S&P500 (a stock market index in the United States) epitomises the private sector’s success in achieving this end. Including dividends, the ASPI is up ~24% and the S&P500 is up ~11% in the thirty year period ranging from 1985 to 2015; whilst, the average 12 month treasury bill yield averaged ~15% and ~5.0% in Sri Lanka and in USA, respectively, during the same time period. Alternatively, an investor who deposited a 100,000 LKR in the ASPI and a 1000 USD in the S&P 500 in 1985 would have made ~Rs.63M and ~$23,000, respectively, at the end of the thirty year period; whereas, an investor who invested the same amounts in 1 year treasury bills of Sri Lanka and USA in 1985 would have only made ~Rs.6.6M and ~$4300 respectively, at the end of the thirty year period.

*SEC.gov.lk*

Not every company in the ASPI or S&P500 has done well over the long-term. PC House, which was once a Colombo stock market darling at an all-time high of Rs.32 per share, is now trading at ~Rs.0.10 cents per share.  Similarly, Nokia, which was at $55 per share in March of 2000, is now trading at ~$5 per share.

Picking individual stocks that beat the market return is a task that only a few have accomplished over the decades. If one has read John Bogle’s book “Common Sense Investing,” one would note that even the asset management industry as a whole has failed to provide a return in excess of the market because of its exorbitant fees and short term incentive structure.

Therefore, if one lacks the skill or passion for investing in individual stocks but prefers a long-term holding period, investing in a broad portfolio of stocks which tracks the market index is the best strategy to secure a worthwhile return. In order to execute this strategy in the United States, Warren Buffet suggests opting for low cost exchange-traded fund that tracks the S&P500. An equivalent option in Sri Lanka would be to purchase a weighted number of shares by market capitalization of the top 50 companies in the ASPI.

This common sense strategy, however, requires emotional resilience in times of market distress. In the scenario that one had started to follow this strategy in 2006, he/she would have incurred a 50% tumble in the portfolio during the 2008-2009 recession. However, both market indices, the ASPI and the S&P500, recovered in due course and are now significantly above their 2006 highs, giving those who held their shares through the market turmoil a sufficient gain.

In the midst of the 2008-2009 financial crisis, when everything looked like doom and gloom, Warren Buffet stepped in and bought billions of dollars’ worth of shares in US banks and credit companies, giving a vote of confidence to what was at the time a fragile US financial sector. Likewise, despite the sovereign debt troubles Sri Lanka is currently facing, Dhammika Perera bought a majority stake in Singer PLC just last month, displaying his optimistic outlook on the long-term prospects of Sri Lanka

Following the passive investment strategy outlined above through the short-term ups and downs of the market is a similar bet on the longevity and dynamism of the private sector to that made by Dhammika Perera. The only difference is that the passive strategy takes a lot less effort.