Investing in Peaks-What are the odds?

So, here is the question. Should you invest in Indian markets when Sensex is at its all-time high? What are the odds that you will make money from this point forward?

It is quite common sense to avoid investing in peaks and invest during troughs (when market hits a bottom). However, this is easier said than done. What if the market is in a secular bull run? Are we not missing an opportunity to make money by not investing just because the market is at an all-time high?

Ironically, markets come to investor attention only when they touch all-time highs. But all time high is also the point where prospective returns are diminished considerably. A look at Sensex from 2005 to 2014 (10 years) says that it provided an annual return of 15%, sufficient to be attractive even if you factor inflation into the equation. However, this assumes that you invested at the beginning of 2005 and never looked back, an assumption that is not easy to make. When markets are in peak, investor sentiment is also at a peak encouraging one to invest. Also, peer pressure to perform also increases as you see your friends and colleagues making money (or at least boasting to be making money). 

Alternatively, when markets are in a trough, fear factor will rule and may force you to cash out earlier instead of investing.

We ran a simple number crunching exercise to differentiate the effect of investing in a peak as opposed to investing in a trough for the Indian market. However, we need to formulate some rules to test the case. Here are they:

       1.       As an investor, we expect to make an annualized return of 15% (approximately the return Sensex gave during the last 10 years. This is our target return.

      2.       Our holding period is a minimum of one year since we are not in a trading environment where we buy today and sell either today or tomorrow for a 0.2% return in a day. Annualized, this can be equivalent to making or losing 65%!

      3.       A PEAK is defined as an all-time high that we have never seen before (quite easy to spot as well). For e.g., the current Sensex level is an all-time high.

      4.       A TROUGH is any point 15% lower than a latest peak. (The 15% is subjective and is set to align with the long-term performance of Sensex)

Here are the results:

During the ten year period (2005-2014) Sensex produced 220 peaks (all-time highs) out of which 165 happened before Jan 1, 2014 (since we have a one year holding restriction!). Out of 165 peaks, 129 hit the target return of 15% with an average holding period of 252 days (one year in terms of trading day’s calendar). In other words, 78% of the time you would have achieved your target return of 15% exactly within one year of holding period even when you invest in a peak. So, what happened to the balance 22% of the time? The holding period for them is 1,742 days (approximately 7 years) and still counting!

In the same ten year period, we had 902 troughs out of which all of them are more than 1 year old (remember we are in a bull market for the last few years). In all of the trough cases, we achieved our target return of 15% within one year holding period. In other words, the odds of not making 15% target return when investing in a trough is NIL.

In other words, when you invest in a peak there is a 22% chance that you may have to wait endlessly to make a 15% annualized return. While when you invest in a trough, there is no such risk. The question now is, is the 22% risk of being caught in a peak trap worth taking? It depends on your risk appetite.

Amazingly, Indian markets have provided far more troughs than peaks! Troughs outnumber peaks 4 to 1. So why not wait for the trough rather than getting sucked up in a peak. While the odds of being on the wrong side of a peak investment is just 22%, when you are the odd man out in that group, your waiting time to realize your target return can sometimes be endless (ask a Japanese!).

PS: The author thanks Rajesh Dheenathayalan for his assistance.