What Kind Of Investors You Are—Smart, Amateur, Passive?

Investing is more of science and a bit of art; the skills needs to be mastered over time. To prove this, we tried to analyse if smart investors can earn excess return over amateur investors and passive investors.

An investor, who has an understanding of analysing companies can draw correct and timely conclusions from ratio have access to financial databases, statistical tools, research reports, can be classified as smart investor. A smart investor can be expected to make smart decisions and hence he/she would invest in stocks when those are trading near the bottom and there is a huge upside potential.

Similarly, we can have investors with poor knowledge of financial products classified here as amateur Investors. This category of investor generally trades in stocks because their colleagues’ share stories of how they have made fortunes in investing or they have learned some new skills and wish to try if it works for them. These Investors generally end up investing in shares at their peak levels and even after holding shares for couple of years discover that they ended up losing capital or earning poor returns.

The third category is classified as passive investors who are those who bet on quality stock and invest in a time bound manner, for example consider an investor who invest all his bonus at the end of every year in either index or some selected stocks, such kind of investor know that they have limited skill set and also realizes the potential of equity investing and so at the end of year whatever is the surplus he parks in good quality stocks or Index.

Instead of using couple of shares and measuring the performance over time we used daily Index values of S&P BSE Sensex and NIFTY from 1 January 2005 till 31 Dec 2015. Using index values also helps us in eliminating any sectoral biases and liquidity issues. From the daily index values we obtained their fifty-two week highest and lowest points for all the ten years and calculated their spreads within each calendar year.

Table-1

In table-1 we can see that the spread between maximum and minimum index values was maximum in 2008, this was principally due to financial crisis originating in US. Excluding 2008 we observe that the average spread is close to 1700 point for NIFTY and 5000 points for Sensex. This also means that every year for some reason equity market makes new highs and new lows and the gaps are very substantial.

Smart investor should be able to gauge where the markets would bottom and invest; whereas amateur investor would make an investment decision when the markets is at its peak as they are influenced to take a decision when they hear stories of rags to riches in media and everyone around them is talking of investing replicating the herd mentality. On the other hand, passive investor invests at a particular frequency and we have assumed that every year they invest on January 1 in Index.

Index returns were calculated assuming that investor invested in the index at the highest /lowest points and remain invested till December 31, 2015. CAGR was calculated assuming that smart investor will invest in Index when it is at 52-week Low and amateur investor will enter the market at its yearly highest point and passive investor will invest on January 1 in Index every year.

In table-2 we can see that smart investosr have made average profit of 13% by investing in stocks at yearly lows and their CAGR ranges from 5% to 17% calculated from Nifty values and similar results can be seen for S&P BSE Sensex

What is intriguing is those amateur investors have ended up earning average returns of merely 3% from Nifty and S&P BSE Sensex. The range of return varies from -12% to 10%. The spread of the smart and amateur investors is as high as 19% in year 2014. The average of spread between smart and amateur investor is around 9%. This is substantial evidence that share markets have great potential and rewards smart investors.

We can also see what returns would passive investor earn if they make regular investment in stocks on a particular date (1 January) of every year, the results are indicated in the last column of table-2. Passive investors have earned CAGR of close to 9% which is 4% lower than smart investor but 6% higher than amateur investors. The results obtained would have been different if we choose to make regular annual investment on some other day of the year, but the conclusion that we can draw will still remain valid. Long term return of 9% excluding dividend incomes should be considered as decent return for wealth creation.

For retail investor the message is that it is very difficult to time the market and earn excess return every year, even experts with deep understanding and great skills find it difficult. But it is best for average investors to stick to a regular investment plan and without bothering about the index or stock movement they should invest at regular intervals. Retail investors with limited market insight should avoid timing the market instead carefully choose stocks /index and over a long run they would earn excess return over the long term yields from bonds or fixed income securities.