Consider the risks, rewards of long-term planning before investing

By Priya Sunder, Livemint article posted on 27 Jan 2020

A longer holding period provides greater ability to ride through market cycles

As we enter 2020, let’s reflect on the decade that has gone by and what it meant to investors. The year 2010 started on a slow note for equity investors and the markets moved sluggishly till 2013. The tide turned in 2014, when the markets picked up by nearly 30%. A slump followed from 2015 until 2017, until the markets again climbed 30% from the previous year. Since 2018, the financial markets have witnessed some very interesting times.

Even though the mutual fund industry saw its assets under management grow over four times in the last decade, the last year saw unprecedented turmoil. The NBFC (non-banking financial company) liquidity crisis in 2018 resulted in the debt fund industry reeling from several credit events. Many equity funds also slipped into the red for most of 2019 though they have picked up momentum after the recent market uptick. Amid such turbulence, the investors who emerged victorious in the last decade were the ones who stayed true to their asset allocation and held on for the long term.

Long-term investing enables you to focus on what you want your money to accomplish over decades, not just months. Short-term planning, on the other hand, sways you in favour of emotionally-driven irrational behaviour. In such a situation, you may forget the rationale behind why a certain investment was recommended in the first place, and deviate from course. Your behavioural biases of greed and fear may interfere with carefully thought through investing strategies, causing you to either buy high or sell low. When the turbulence settles down, it can be difficult to bring the plan back to its original course since you may have lost significant time or money.

It is impossible to consistently time the market. In the short term, it is but a zero-sum game. Several studies have shown that the longer you stay invested, the higher your return on market-linked investments. A longer holding period provides a greater ability to ride through market cycles and recover from recessions. Hence, the probability of generating higher average returns on your investment increases with time.

Given that long-term investing has such strong benefits, what are the risks to such a strategy? Long-term investments are subject to four main risks: assumption risks, longevity, unforeseen cash outflows and black swan events.

When we create a financial plan that projects the future for several decades, it is based on the bedrock of certain assumptions. Such assumptions are made around returns of different asset classes, inflation, taxation, income and expense patterns, and risk appetites of investors. When some of these assumptions do not play out into the future, the long-term projections start to falter. For example, return expectations on equity and debt are usually based on historical data, which may not be an accurate predictor of future returns. Tax laws may change, impacting the overall return on investment, or inflation can be higher or lower than anticipated.

Living long and dying young are both undesirable from a financial planning perspective. Living too long necessitates stretching your money for longer than planned. Hence, if the plan assumes the average Indian male life expectancy as 75 years, but improved healthcare increases it to 90, the current plan may not sustain the money flow for the additional 15 years. Dying too young poses a similar problem. You expect to generate a certain income stream to build assets to support your family’s goals, when sudden death puts a brake on cash inflows. Hence the existing, limited assets are stretched to fund immediate and future goals.

Unforeseen expenses or unexpected job losses may force you to redeem your investments before time, sometimes at a loss, thereby shortening your investment tenure.

Black swan events such as the subprime crisis of 2008 or even natural disasters and wars can easily throw a well-crafted plan off kilter because such events not only erode your asset value but also have a deep psychological impact, where fear overrides rational decision making.

It is true that the future is uncertain. However, even if we cannot predict the future with a high degree of certainty, we do have the ability to make calculated assumptions, and this forms the basis for all financial modelling. Monte Carlo simulations, for example, help to model for risks in a plan by exploring the sensitivity to assumptions made, so that those can be factored in and planned for accordingly.

It is important to remember that a well-crafted financial plan factors both positive and negative outcomes. So, as long as you stay within the plan, you are more likely to achieve all the milestones across different time horizons. Simply put, a long-term view does put you years ahead of your investing game.