How Patience And Quality Intervene?

Let us introduce a term called the ‘patience premium’. This is the difference between annualized returns generated by a stock or an index over any holding period compared to the return generated by the same stock or index over a one-year holding period. 

A positive value of ‘patience premium’ implies that the longer the holding period of a stock, the higher is the return generated from it for an investor.
 For example, if holding stocks for five years gives you 10% annualized returns whereas holding stocks for one year gives you 7% returns, then, the patience premium is 3%. 

Adding Quality premium over Patience premium.

Quality premium is the difference between the annualized returns generated by a stock or a Portfolio and the benchmark index over a particular holding period.

Positive value of the quality premium implies that increasing the quality of the stock portfolio generates better returns for the same investment horizon.

For example, If a person's portfolio generates a return of 17% and Sensex generates 13% during the same tenure period, the Quality Premium for the person's portfolio is 4%.

The probability of generating positive returns increases with the holding period of BSE sensex.

Government Bonds with 8% annualized returns are less risky than a stock with the same returns over 10 years as it is less volatile.

Standard deviation (the measurement of volatility) shows that risk involved in a 1-year holding period is 3 to 4 times higher than the 5-year bonds .

BSE Sensex’s one year investment horizon is the riskiest with risk levels being 6 times higher than that of the 10  Year horizon.

The Risk Vs Return trade off for the Sensex improves as the holding period rises.

The best way to grow one’s wealth, therefore, is to have high returns with low risk i.e., equity investment for a long holding period.

Observation 1: The shorter the holding period the higher is the  quality premium

Author has compared the coffee can portfolio as Rahul Dravid and Sensex to Virender Sehwag. He has made an interesting comparison between the batting averages of two cricket legends. Dravid was a great defensive batsman with an effortless batting style which lacked flamboyance—characteristics that sound perfect for the test match format. Sehwag, on the other hand, was an aggressive batsman, ready to flirt with unimaginable risks and looking to hit almost every ball over the boundary. The perfect kind of game required for T-20 matches. 

When it comes to the stock market, intuition suggests that shorter investment horizons are akin to speculator investing where investors do not need to focus too much on the quality of the company to generate good returns. 

Over longer term horizons one would intuitively imagine investors would need to rely on high quality companies for superior returns.

However our research shows that while the quality premium exists across all holding periods, for the Coffee Can Portfolio - the quantum of the quality premium is higher for shorter holding periods (3-5 yrs) compared to longer  holding periods (7-10 yrs).

Hence, the extent of outperformance that an investor can generate by upgrading the quality of his portfolio is greater for shorter holding periods compared to longer holding periods. 

Observation 2: High quality portfolios with a very long holding period deliver the highest return with the lowest risk.

Coffee can portfolios have a better risk-return trade off than the Sensex over all investment horizons.

An investor who is able to combine patience with high-quality portfolio construction thus, pulls off the holy grail of investing—outstanding returns with low levels of volatility. That is the essence of the Coffee Can Portfolio.

The three key takeaways from this chapter:

• Patience premium in equity investing: Given the behavioural concept of ‘Myopic loss aversion’ defined by Shlomo Benartzi and Richard Thaler, investors who do not have even a year of patience, i.e. stock holding periods less than one year, are likely to believe that ‘more often than not, people lose money in equity markets’.
• Quality premium in equity investing is higher for shorter time periods
• Combining quality premium with patience premium: Whilst both the Sensex and the Coffee Can Portfolio (CCP) produce better returns (alongside lower volatility) if held longer, the CCP beats the Sensex by a wide margin when it comes to producing superior returns (with its volatility being even lower than that of the Sensex).