Sunday, January 29, 2012

Long Term Equity Investment: Philosophy, Science and Art


Return on equity shares is a risky variable. The data on past yearly returns on equity shares can be seen and the risky nature of return on equity shares can be observed and confirmed. My doctoral thesis was on return on equity shares in India during 1953 to 1987.
Theoretically also, we can grasp the variability of return on equity shares. Equity shares represent a part ownership of a business concern organized as a company or corporate concern under the company law of the country. A business owner earns his return through the profit made by the business after paying out all the expenses including rent for the landlords, wages and salaries for the employees, and interest for the capitalists. Hence profit is a residual item and it fluctuates from period to period. Therefore, the return that a company can directly give its shareholder which is dividend can fluctuate from year to year.
Equity shares can be sold on the exchange at any point in time. The sale price can result in a capital gain or loss. The sale price fluctuates in the market on transaction to transaction basis depending on the demand and supply. Hence the capital gain or loss can fluctuate from period to period. Thus on both dividend return side and capital appreciation side return on equity shares have variability and hence return on equity shares is a risky variable.
If an investor can take the risk and bear with the fluctuations in the return from period to period, he has the opportunity of earning a higher expected rate of return compared to the low risk investments alternatives.
If bonds are offered a more certain or less risky returns, the expected return offered on them will be less than that offered on equity shares.
To bear the risk of fluctuation from period to period and earn the expected return, an investor in equity shares is supposed to hold it for long term.

Science of Long-Term Investing in Equities

Equities are risky securities. They are entitled to residual income of the company and this residual income fluctuates from year to year. From an income perspective, equity investor cannot be sure of the quauntum of the dividend. An equity investor has to sell his holding in stock market to potential buyers at rates prevailing in the market. Valuation of equity shares is based on expected profitability of companies and riskiness of the profitability. Historically it is seen, that expectations have huge swings. Hence, for any fixed duration, estimating a return on equity shares is an exercise in uncertainty. Any phenomenon, subject to a range of possibilities results in a value close to expected value over repeated number of trials. Hence, the actualy return on equity shares will be more closer to the expected value over long-holding periods.

Art of Long term Investment in Equity Shares

The practice of any subject based on science is an art. A scientist has to be an artist to communicate his research to other researchers and laymen. When we want to talk about art of long term investment, we have to locate long-term investors. The best and most widely known person is Warren Buffett. He is not into day trading and position trading.
The knol will be  further extended. 

Related Knol

Graham-Rao's Method of Analysis for Long-term Investment in Equity shares

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