Trading Rule – “Always keep an eye on your pay-back period”

WHAT DO WE UNDERSTAND BY A PAYBACK PERIOD? OBVIOUSLY, IT IS THE TIME IN WHICH YOU RECOVER YOUR PRINCIPAL. YOU MUST HAVE HEARD OF THIS CONCEPT IN LARGE PROJECTS BUT HOW IS THIS IDEA RELEVANT WHEN IT COMES TO EQUITIES. FIRST LET US UNDERSTAND THE CONCEPT OF PAYBACK PERIOD. LET US ASSUME THAT YOU HAVE INVESTED RS.10 LAKH IN AN EQUITY SHARE AND THE YIELD ON THE STOCK HAS BEEN AROUND 10% ANNUALIZED. THAT MEANS YOUR PAYBACK PERIOD JUST TO RECOVER THE PRINCIPAL IS 10 YEARS. THAT IS OBVIOUSLY NOT TOO EXCITING

PAYBACK APPLIED TO YOUR INVESTING ACTIVITY

When we talk about investments we are obviously referring to long-term investing. There are different ways to look at the payback. For example, if the P/E ratio is 20 that means your earnings yield is 5% and therefore it will take 20 years to recover your investment purely measured by the earnings of the company. However, you invest for growth and for price appreciation. A more relevant measure will be the payback calculated by the average returns over the last 5 years. Let us understand this concept with the help of the index. The Nifty has given a return of around 12% annualized in the last 20 years. That means it takes an average of 8.5 years for you to recover your capital and that is your payback period. For the sake of simplicity let us ignore the time value of money. You can also consider the P/E ratio of the Nifty at 20 as the payback period, but that ignores the actual market returns.

PAYBACK APPLIED TO YOUR TRADING ACTIVITY

Interestingly, the concept of payback can be applied to your trading activity too. Remember, your trading activity carries a higher risk and therefore the reward should be relatively higher than your investing activity. How do you calculate the payback period for your trading activity? Obviously, you will have to consider the average returns on your trading account over the last 3-4 years. Let us say you have earned a return of 30% on your trading account annually in the last 3 years. That implies a payback period of a little over 3 years. That is still understandable. But if you consider the taxes on your trading activity at around 30% then your effective returns net of taxes will only be 21% and your payback period will be nearly 5 years. Having done this analysis, you need to also see how much you have actually earned vis-à-vis the brokerage that you have paid. If half of your profits are going away because of brokerage and statutory charges then you need to rethink your trading strategy. Payback helps you put your trading activity in the right perspective. If you can earn 21% on passive investing in mutual funds, then you are really wasting your time trying to trade and time the market.

“Never commit the mistake of mixing your investment and trading activity in the same account or in the same mindset” – The Intelligent Investor

6 REASONS WHY PAYBACK PERIOD ANALYSIS IS IMPORTANT…

  1. Understanding the payback period helps you to put your investment activity and your trading activity in the proper perspective. Every investor or trader has to make a choice of active versus passive. Payback gives you a quick analysis of whether you are really being profitable by being more active and aggressive in the market. If not, either change your strategy or shift to a more passive approach to equity markets.
  2. Payback period puts your P/E ratio in perspective. Your P/E ratio is nothing but the reverse of the earnings yield of the stock. The earnings yield determines how much time it will take for the company to earn enough to justify the price you are paying. While P/E ratio as a concept of valuation is great, it is only when you understand P/E ratio in terms of payback period that you are able to appreciate your opportunity costs.
  3. There is an interesting analysis that payback period throws up. You can calculate payback period based on the earnings of the company or based on the returns of the stock. If the gap between the two is very large, it is a quick indicator of the extent of under-pricing or over-pricing implicit in the stock price.
  4. Payback period does not capture the time value of money. The idea is to keep the concept as simple as possible. By focusing on the time required to recover the investment it gives two perspectives. It enables a quick comparison with alternatives and secondly, it also cautions if the cost of trading and investing is actually spiraling out of control.
  5. Payback audit trail is a good metrics for comparison of your performance in the markets over a period of time. Ideally, your payback period in equity investing and equity trading is a good indicator of whether your performance in the market is improving or falling over a period of time. This enables you to highlight problem areas and take corrective action at the earliest.
  6. Payback period gives a time dimension to your stock market activity. As Keynes said, “In the long run we are all dead”. Therefore it is more important that we survive today and tomorrow if we really want to survive in the long run in markets. Payback period brings a very granular perspective to your trading and investing by giving it a very important time dimension and infusing urgency into your actions.

PAYBACK HAS LARGER IMPLICATIONS AND ACTS AS A WARNING SIGNAL

Payback is not just about recovering your capital investment but also about bringing a time-bound urgency to your activity. In the financial world where there are a plethora of investment choices available in front of you, the payback period analysis helps you to put the various options in the right time-dimension perspective.

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