8-Dissertation - CYTL 2012-Akash Shetty

7/30/2019 8-Dissertation - CYTL 2012-Akash Shetty

1/10

Presented by- Akash Narayan Shetty

Master of management studies (Mumbai University)

S.I.E.S College of management studies

For Crisis young thought leader 2012

October 2012

Does the 'Buy and hold' strategy really work amid the

current hi h volatilit in e uit markets?


2/10

S.I.E.S college of management studies Page 2

FLOW OF REPORT

Sir

no

Topic Page no

1 EXCUTIVE SUMMARY 3

2 INTRODUCTION 3

3 ORIGINATION OF BUY AND HOLD STATERGY 4

4 APPLICATION OF BUY AND HOLD STRATERGY 4

5 UNDERSTAING BEAHAVIOUR OF EQUITY MARKET IN LONG RUN 7

6 CONCLUSION 10

7 BIBLIOGRAPHY 10


3/10


EXCUTIVE SUMMARY

In 1969 if someone had invested $100,000 in George Soros set up quantum fund, hisinvestment (presuming that dividend were reinvested) would have grown to $130 million by thespring of 1994 a compound growth rate of 35 % over a period of 25 years. Even if anyoneinvests in a basket of blue-chip Company and holds it for 30 years hes bound to be billionaire,right? Not in Japan. Nikkei is at same level as it was trailing in 1982; there would be nodifference in value of investment in this 30 year period if anyone would have invested there. TheJapanese market is not alone who demonstrated this trend. Stock indices of the European marketsare down to 14-15 year lows. But investment in market like US and India are performing betterwith benchmark indices of their 2007 levels.

With zero gain or even negative gain (considering inflation) after long period ofinvestment, the strongly held strategy of long-term investment looks like dying. But financialexpert and leaderdont get tire of preaching that holding stocks for the long period of time willmake u rich. We will try to understand this buy and hold long term strategy in this reportexamine its foundations, its benefits and long term investment during boon and financial crises.

We will also discuss some wrong perception of investor in 21 st century and try to correct it withfinding. This report in divided into two phases, in first phase we will discuss about how buy andhold long-term investment strategy is applied. Then will move on to general misconception ofpresent investors unveiling various trend related to buy and hold strategy. We have consideredS&P 500 index for most of our analysis and US investment market since it have long history andmore relevance in buy and hold strategy.

INTRODUCTION

Investment firm usually attract investor with concept of long term investment whichguarantees high returns but there long term is not defined. The Indian stock market (NSE)have not generated any return in last five year, but if we see developed market like French,Germany, British, Spanish and Italy they will show worst performance as they are in sameposition as 13-15 year ago. US DOW Jones is still little above its level in 2007. If fund managerare not getting there desired result in 2-3 year for there client, time horizon is extended to fiveyear, or even future to 8-10 years.

So should we conclude that investor have to desert equities and focus their investments inthe low deviating return giving assets like debt, gold and immoveable property? Well certainlynot. Index chart will not show flat line for Indian and most other market as there was bullishphases and bearish phases. Accumulating profits periodically is perhaps the sole way to makeserious money from this volatile stock market and in this report we will cover this conceptrelevance in todays market.


4/10


60%

40%

PORTFOLIO

S&P 500

GOV

BOND

ORIGINATION OF BUY AND HOLD STATERGY

This strategy came into existence by more than 50 years of academic research, wherethey tried to find critical factor in investment return. Nobel Prize winners in economic sciencelike Harry Markowitz, a 1990 Nobel laureate; Eugene F. Fama, Robert R. McCormick, Brinson,Hood and Beebower, and Rex A. singuefield are people who poured light on this topic.

The top gear Buy-and-hold strategy will not ask u to read 2-3 business newspaper a day,glue to news channel, follow investment Guru or keep sharpening your economics. Here wecreate one sophisticate well diversified portfolio by adding undervalued stocks, small companystock, and bullion to a traditional large-cap stock and hold it for long period of time raging from5 to 30 years (long-term is not defined). But we have to understand here that this strategy is notfor every one. It requires undisputed commitment from investor who should not try to reevaluatehis portfolio every month or quarter due to sudden change in market. So here investor are notmanic to not react to unwanted happening in last quarter or next quarter or next year, but he hadformed his portfolio after selecting stock with fundamentally strong growth prospect in longterm.

APPLICATION OF BUY AND HOLD STRATERGY

So how do buy and hold strategy really work? Does it really give high return in stockwith same amount of risk as bond? To answer this let us try to construct one portfolioconsidering investor of US, investing during 1970s and try to find real effect of ultimate buyand hold strategy on investment value in 2011.

A- BASIC PORTFOLIO FOR BUY AND HOLD.

Assume that this investor have invested his money in two assets, 60 percent in stock(standard and poors 500 Index) and remaining 40 percent in government bonds.

Figure-1 Table-1

Now here stock will take care of long term growth while the bond will consider stabilityand regular income aspect for investor. But this will not be optimum portfolio especially foryoung investor who will not like to include bond in his portfolio. But this is industry standard sowe will use it throughout this report to convey our point. Now for 42 years, this portfolio willgive compounding annual return of 8.4 percent and have standard deviation of 12%. So we cansay any other portfolio which will give higher return with same or lower standard deviationwould be better option to adopt. Even though bond is important part of portfolio managementsince its deviation increase with increase in term but our point of attention is 60 percent

BASIC PORTFOLIO ( January 1970 to December 2011)

Return Standard deviation

Basic 8.4% 12%

$100,00 will grow to $ 297,213


5/10


36%

40%

12%

12%

PORTFOLIO

S&P 500

GOV

BOND

US small

cap

investment in stock, so let us look can investor increase his return by different buy and holdstrategy in stock market.

B- EFFECT OF SMALL CAP COMPANY IN PORTFOLIO FOR LONG TERM.

Now if investor is not satisfy with give 8.4% return he will look for better investmentopportunity with same risk. We will try to reevaluate our basic portfolio by adding investment inreal estate to give it realistic picture. Real estate investment trust, or REITs, will decrease riskand increase return since it has 10.8% compounded return.

In our basic portfolio our stock allocation was in 500 largest U.S companies this willinclude company like P&G, Microsoft, Pfizer and general electric. Now this was not billionDollar company since inception, like Microsoft which is classic case of rate appreciation of shareprice. When investor is able to find such companies which can grow at much faster rate compareto large business, he can diversify his stock portfolio by allocating portion in it. Usingperformance of U.S Micro cap fund of Dimensional fund (which invest in bottom 6%-7%companies) as proxy we can calculate new portfolio return and risk represented in below chart

Figure-2 Table-2

With allocation only 12% in small cap we are getting appreciation in final value of$71,423, increase of nearly 24% and getting return of 9% over 8.4%. Risk had also reduced to10.9% since chance of loss is just 12% of allocation but prospect for growth is very huge. Butimportant point to note here is that if investor is ready to take higher risk and invest fully ingrowing small cap the difference of return would have been seven time the entire investment of$10,000.

C- IMPACT OF VALUE STOCK IN BUY AND HOLD PORTFOLIO.

Companies with rising turnover, profits, market leaders, or in process of becoming oneare known as growth stock. Such companies are included in our basic portfolio S&P 500 stocks.We know that as value of company increases the chances of getting higher return in long termreduces so why should investor invest in such large company? Answer for this would be valuestock. When stock of large company which is out of favor due to some unsystematic risk, butthey have potential to return in normal level, are called value stock. Here investor will use

BASIC PORTFOLIO ( January 1970 to December 2011)

Return Standard

deviation

Basic 8.4% 11.8%

Adding real estate 8.7% 10.6%

Adding small cap 9.0% 10.9%

$10,000 will grow to $368,636

Difference of first portfolio final value from presentportfolio final value is $71,423


6/10


12%

40%

12%

12%

12%

12%

PORTFOLIO

S&P 500

GOV

BOND

US small

cap

REITs

US large

value

US small

value

price/book ratio and try to find bottom 30% large-cap values company. Lot of research has beendone on this approach and important finding is that, out-of-favor value stock have majority oftime out performed popular growth stocks.

I

Table-3

If we take U.S large cap value Index and U.S small capvalue Index of DFA U.S as proxy portfolio return willboost to 9.8% and standard deviation is also little less thatfirst portfolio. With this we can see what extraordinaryperformance buy and hold stocks show. If used wiselygrowth of $210,678, more than 200% of basic portfoliofinal value. We have not included investment ininternational market due to constraint presentation.

Figure- 3

With this we can say that how "Buy and hold" strategy was effective in this fluctuating equitymarkets till date and helped investor to get higher return. But is this strategy relevant today? Canwe use this in present market where economic cycle has changed to 2-3 years from 7-8 years?Where tenure of company CEOs have reduced, 100 of products are launched every day,company are cannibalizing there own products. We can not predict future but we can try tounderstand history and answer some question which are been raised about buy and holdstrategy in stock market in following part of report.

BASIC PORTFOLIO ( January 1970 to December

2011)Return Standard

deviation

Basic 8.4% 11.8%

Adding real estate 8.7% 10.6%

Adding small cap 9.0% 10.9%

Adding value stock 9.8% 11.7%

$10,000 will grow to $507,891

Difference of first portfolio final value from present

portfolio final value is $210,678


7/10


UNDERSTAING BEAHAVIOUR OF EQUITY MARKET IN LONG RUN

Now taking about general retail investor and portfolio manager whose biggest source ofanxiety is market volatility. Learning the economic of equity market related to volatility can bestepping stone in the prudent management of our portfolio using buy and hold strategy.

It would be unwise to say that when our equity portfolio has fallen by 10% or more stayinvested and do nothing. We can say its risky if we compare to supposedly risk freeinvestment for example long-term government bonds or money market funds. But if we try tostudy one of the richest investor Warren Buffet and other successful investor they avoidtemptation to adjust their portfolio in response to short term dip in market. We will try to unveilsome of most debatable point in market and try to get excess return by going against the tidebeing wise investor.

1- Volatility of equity returns in todays time is more than 25 or 30 year ago.

Finding- Now we cannot deny the fact that there was upswing in volatility, which can be

measured by price movement. If we track S&P 500 Index movement up or down by 1% or morewe will get 136 such days in 2008- at the peak of the financial crisis. When tracked movement ofsame in 2006 just two years earlier it was 30 days. But if we remove past 30 year record for sameindex we get following finding as shown in below figure

This cyclicality is part of a long termpattern as shown in this chart of dailyvolatility (measures in base point)have fluctuated repeatedly in cyclesover the past 30 years. This sharpdaily movement which will neversettle does not tell full story. We are

though in our investment class tomeasure risk using standard deviation() of return. By using this measurewe will find that value of equitymarket have change but market riskhas not increased remarkably over thepast 35 to 40 years. If we consider lastfull decade which include worst stockmarket events like Internet bubble and

Figure-4

The great recession, the standard deviation of equity market return for largest stock market USwas 18.7% which is little more volatile than 17.6% found in the decade ending of 1990 and17.2% in earlier decade ending.


8/10


2- When price of stock rise or investor gain profit due to bullish period, portfolio theory

(law of averages) says chance of getting high return in future reduces.

Finding- If we consider market return in late 1990 or by 2007 or even during mid-2000 it wasvery high when benchmark was past returns. But we should not be misguided that our future

return would be below average in the future since it was above average in past years.

3- Investor who pump money in stock market when market start to rise, otherwise stay in

cash are smart investors.

Finding- Even well trained or experiences professional investors cannot perform consistently artof timing the market exactly. So when this investor are out of market for even 30 40 days cost

can be enormous. As we can see inbelow chart which show returncalculated for more than 7000 Tradingdays.

Now if investor misses 50 days whichrecorded biggest positive movement hewould have also lost 98% of the totalreturn during that period. Which alsolead to reduction of total return from8.4% P.A to only 0.2% P.A. same wayinvestor missing 10, 20, 30 or 40 dayswhich noticed biggest up days wouldhave bear different amount of cost.

Figure-5

4- Considering the high risk in short term the long-term return paid by stock which is eventhough higher than bonds or treasury bills is not that justifiable. This extra return in stock is alsodue to some boom period in stock market which probability is also not consistent.

Finding- When we see 84 year of historic return in stock market it have clearly beaten cash andbond with huge difference, rewarding the high risk. If we consider our investment in largecapitalization US stocks at start of 1926, that portfolio value would have been grown to 3 lakhpercent of the beginning value. Now if we replace this portfolio investment by long termgovernment debt it would have grown to 9,200 percent, while if we consider investment inTreasury bill it would have grown to only 2,000 percent.

Now considering such high return for equity market its volatile was also recorded higherthan bonds or treasure bills, but 72 percent of time this volatility was positive in 84 years as


9/10


shown in below figure. Only 12 percent of time investor had to burn there hands by loss greaterthan 10 percent and 7 percent of time loss more than 20 percent. When we talk about return more

Figure-6

Than 10 percent, an occurrence of it was 57 percent of time and more than 20 percentreturn was 37 percent of time. So overall almost 69 percent of time stocks outperformedTreasury bill and long-term government instruments and probability of occurrences was alsohigher. So assumption that high return in equity market is due to few boom periods in stockmarket can also be negated. If we break investment periods from 1945 till date into 10-yearsperiod, stock market have out performed long term debt market 80 percent of time.

Figure- 7


10/10


CONCLUSION

With our finding we cannot guarantee relevance of buy and hold long-term investmentstrategy. Outcome of this strategy is ultimately depend on selection power of investor as quitepossible the value stock or growth stock which we chose can underperform over next 5,10,15,20

years. There are many uncertainties which are simply inevitable. Still we can say that buy andhold strategy deal very well with it. If we own well diversify portfolio even if it consist of onlystocks, we would be not overly depended on any particular sector or company. Real concern isnot only volatility of market, but also the loss that can occur due to sudden or quick reaction ofinvestor by changing long-term strategy which they may regret later.

BIBLIOGRAPHY

1- Wealth report, 13 August 2012 economic times.2-prasanna Chandra,portfolio management.3-Fidelity research report2012.

4- World economic forum- www.weforum.org.5- http://www.standardandpoors.com6- http://corporate.morningstar.com7- www.ifa.com reports8- http://www.dfaus.com10- www.scottsinvestments.com/2009/04/
http://www.standardandpoors.com/http://corporate.morningstar.com/http://www.ifa.com/http://www.scottsinvestments.com/2009/04/http://www.scottsinvestments.com/2009/04/http://www.ifa.com/http://corporate.morningstar.com/http://www.standardandpoors.com/

Documents

8-Dissertation - CYTL 2012-Akash Shetty