InvestorQ : Why is there so much focus on taking a long term approach to investing in the equity markets and also in the case of equity mutual funds?
Moii Chavate made post

Why is there so much focus on taking a long term approach to investing in the equity markets and also in the case of equity mutual funds?

Sam Eswaran answered.
3 years ago

What is the ideal holding period for your mutual funds? Obviously it will vary depending on whether it is an equity fund or a debt fund. For example, liquid funds will give roughly the same annualized return whether you hold it for a period of 15 days or 45 days or even 180 days. That means, in case of liquid funds, the holding period does not matter and they are best suited for short term investments. As you go higher on the maturity graph like liquid plus funds, short term debt funds, income funds, credit opportunity funds etc, the time period of holding goes up further. Then you have the risk assets like balanced funds and equity funds which entail a much high degree of risk. You can only look at these investments if you have a really long term perspective. They can be notoriously risky in the very short term and even in the medium term.

Does long term approach always work in case of equity / debt fund SIPs?

When you do a SIP, you have the natural advantage of rupee cost averaging (RCA). However, even then, your time frame cannot be out of sync with the assets you are investing in. What do we understand by medium term and long term in the case of mutual fund investing? Let us forget about the short term for the time being. The medium term refers to a period of 3-7 years. Here, one can look at long term debt funds, credit opportunity funds, MIPs, FMPs and even balanced funds. Investors have the leeway to go for longer duration bonds and also for partial equity risk. Any investment beyond 7 years is classified as long term investing. Typically, goals like your child’s education, your retirement etc will fall under this category. Here, you can deploy higher risk products like index funds, diversified equity funds, mid cap funds comfortably in these cases.

It is about pegging your investment to your maturity risk

Let us look at two different scenarios altogether. Firstly, you invest in liquid funds and short term debt funds for a corpus you require after 12 years. What is wrong here? You are not making full use of the risk capacity that you can afford here. For a 12 year goal, you have a much higher risk taking capacity. You should be using the power of equities to grow your wealth by making money work harder for you. The biggest risk you are running by opting for liquid funds for a 12 year objective is that you are not taking any risk. In Scenario 2, your short term goals are funded by investments in equity funds. This is more risky because you are running a risk of short term underperformance in equities. We all know that equities can be notoriously volatile and unpredictable in the short to medium term. It is only in the long term that these equity products really work well. What is wrong with taking a long term investment approach to a short term goal? The risk is that you may end up with a huge mismatch between your investment sand your goals.

You could fall short on your short term needs if you are invested in equities

Let us say, you plan to pay your home loan margin after 3 years for which you have started an SIP. Instead of a short term debt fund or a liquid plus fund, you have chosen to put money in a diversified equity fund for higher returns. Your target is to reduce your corpus/contribution ratio. What you are not preparing for is the risk of equity market volatility going against you. If a full-fledged trade war broke out between the US and China and your equity markets crash by 20% then what do you do? That is the risk of allocating a long term asset like equity fund to a short term goal. The risk is not in the equity fund but the risk is in the goal.

Don’t underestimate the power of evaporating liquidity

Risk of liquidity is linked to the risk of maturity mismatch. The advantage of liquid funds, liquid plus funds or short term debt funds is that they can be liquidated at short notice without much price risk. That is not the case with equities. If you are in a mid cap fund and if mid cap shares are falling like nine pins as they have done in 2018, then your fund could have a real problem finding buyers for its mid cap stocks. This illiquidity risk will get passed on to you in the form of lower NAVs and you are moving farther from your target.

Nobody wants to sell their investments at a point of distress

In the case of the home loan, if at the end of 3 years, if you are 30% short of your target, what do you do? You need to arrange the funds as you have already booked your apartment. You will end up either taking a personal loan or selling some of your long term investments pegged to your goals like retirement, child plan etc. In the process, you are compromising your important long term goals.

The moral of the story is that only liquid and near-cash funds work really well in the short to medium term. Equity funds work best only in the long run. To avoid risk, you need to take a long term approach on your equity SIPs to really make the best of the market situation. That is when you actually create wealth.


AR Kadam answered.
3 years ago

Equity markets or asset class is very volatile in short run. Also equity is like buying stake in the company's business. No one is expected to make good profits unless he invests for long run in the business. Every business has it's own cycle to deliver returns to it's investor or shareholders.

Therefore there is focus on taking long term approach to investing in equity markets whether directly or through mutual funds.