POWER OF COMPOUNDING (IN EQUITY MARKETS? MY FOOT!)

How often have we heard about equity markets and their power of compounding. Invest your money, allow it to bake for several years, preferably a decade or two, lo and behold, you are ten times richer!

Why, I’d start earning as soon as it is legal and retire at 30! The power of compounding will see me through age 59 when social security takes over! Wow! Never knew life could be this easy! Yahoo! I got it made!
WAKE UP, ASSHOLE!
Uhh? You mean it’s not true?

The stock market ain’t your neighborhood streets where you could bully your way to the prettiest girls! It is a dog-eat-dog world where pension funds, insurance funds, mutual funds, ‘HNIs’, ‘FIIs’, corporates and promoters invest or, as some would say, practice treachery or skulduggery day in and day out against each other and against brokers, day traders and speculators even as the government watches over (not so) helplessly. Nobody, except perhaps your mutual fund if you are invested correctly, has your interest at mind.

But the power of compounding is supposed to....
SHUT UP!.

The power of compounding works when the principal appreciates over time even as the interest rate holds for the duration of investment. The interest rate applies to successively larger bases consequent to which the payout rises exponentially over time. Held for decades, even a meager amount grows to something substantial presuming interest rate are near about the two digit mark.

Shall I switch to fixed income then?
SSHHUUTT UUPP!!

The problem is, one doesn’t have a lifetime to wait for and interest rates seldom are what one would like them to be. Indeed, with periodic exception, interest rates have been trending down even in developing countries. That leaves commodities, gold, equities, land or art as alternative asset classes. Commodities are notably short-term investments. Gold has more than hedged for inflation recently but has been known to sleep for years. Land, hmm, that I could invest in, but the formalities are many and the investment is illiquid. Art? I am not sure it will appreciate what with computers mimicking human brain and hand. What does that leave me with? Oh yes, Equities. Company shares traded in the stock market at prices that supposedly reflects present value of the discounted stream of earnings.

So I should invest in equities? OK, OK I’ll shut up.

Equity markets, despite their risk and volatility, are known to provide returns that approximately match the expected growth in earnings. And there is a theorem that requires risky investments such as equities to, on average, outperform less risky investments such as fixed deposits and sovereign bonds. But, mind you, despite claims to the contrary, there is no assurance of compounding in equity markets. Equity markets are a reflection of the future. If that future becomes hazy or uncertain, equity markets will not rise, no matter how long. What could upend this technological society? Global warming, for which we have barely begun to pay, a growing divide between the rich few and the poor masses that is exacerbated by an incrementally capital-intensive, labor-saving economy that automates jobs performed by the poor masses, failure to invest in technology and brains that reduce competitiveness in the world economy, terrorism, nuclear threat, war, political scandals, social turmoil, rank-bad government policies, corruption, even bird flu – to name few!

One presumes the various hedging instruments in the market today can only serve to reduce the volatility around the return, thus increasing the possibility of gains over time. On the other hand, these very instruments, in combination with index ETFs have been used to destabilize the market. It is no secret that once fear grips investors following a crash, it takes a long time for the market to return to its pre-crash level. Besides, returns depend not only on how long one has held the stock, but also whether one invested at a multi-year high or low and whether one redeemed stocks at a high or a low. Since prices are based on expectations of buyers and sellers, and expectations can be manipulated by deception, rumours or staged one-time events, prices abruptly reverse trends when the expectations are belied. Further, your investments are at risk every time inflation rises, every time a large pension or bond fund believes the stock markets are ripe for a fall or the public votes to power a leftist government that intends to fleece businesses to support the poor (or a conservative government that must set right past excesses of the left!). Why, even low price multiples and high earnings growth don’t guarantee appreciation if the ‘big daddy’ ain’t willing to invest, for whatever reason. Held too short, investments don’t yield a return; held too long, they lose any ‘froth’ that might have accumulated over bull runs. Indeed, making money on your investments is an art; a task that requires constant monitoring of economic scenario, economic data, fund news, upcoming market events as well knowledge of financial markets.

So, the bottom line is...
Shhh!

First, invest on yourself, your health, your education, your career and your home. You will save taxes and do yourself a lot of good! Then, spread your investments over time and across asset and fund categories. When you invest, read the fund objective twice, even thrice and ask yourself ‘Do I agree?’. Move out if a fund engages in practices that are incompatible with your objectives or risk perceptions. Don’t wait for the ‘big daddy’ to shave off the cream during bull runs. Learn to sift crashes that owe to changes in economic fundamentals from manufactured ‘crashes’ meant to shave off the cream or shake off the unnerved and the infidels before another bull run. Pre-empt the former and exploit the latter. Plan early to redeem. Spread your redemptions over a period of time when the going is good. Have emergency cash at home and then 3 to 6 months of living expenses in your checking account. And always evaluate returns in financial assets against returns from investments in higher education or home improvement! The bottom line is nothing beats your monthly pay check – and a second earning member! Earn your pay and keep the job. Save money and early. It is the ‘early’ money that counts toward your future. Invest your early money in equities.

Phew! It’s back to work then?
There, you got it right!