Equities over other asset classes

At a glance

  • Inertia tends to be one of the key reasons most of us do not practice any asset-allocation
  • Equities are one of the more rewarding asset-classes based on traditional risk-return metrics
  • While Indian markets have been volatile (like the rest of the world), there have been more up years than down over the last 20 years
  • Equities outperform Fixed Deposits over the long-term, especially when considering tax impact
  • In spite of inherent volatility, over investing horizons of 5+ years equities are a ‘safe’ asset class
  • Small-ticket, diversification and the real-time learning offered by equities are advantages over other asset classes
  • Therefore equities are an essential part of any investment plan

If you’ve read the ‘Why we invest‘ post, you know that we need to invest to maintain the value that inflation consistently erodes. However, barring emptying your bank account into a gym bag and stuffing it under your bed, most places you park your money, technically, count as “investing”.

Inertia

As of March 2014, Fixed Deposits offer rates in the neighbourhood of 9% interest for lock-in periods of 12 months and more. Corporate bonds offer higher rates than FDs depending on the credit ratings assigned by ratings agencies. There are also more adventurous avenues like real estate that can deliver significant returns. However, based on my own experience and of friends and acquaintances, inertia explains most “reluctant” investors who avoid practicing any kind of asset allocation and typically leave it all in cash, sitting in their savings accounts where it earns a sedate 4% pre-tax (6% in some banks).

Risk versus Return

The rationale for the different interest rates is simple. Higher the risk, higher the expected return. The discussion over risk-return characteristics of different asset classes is a much-documented topic. Monevator offers a succinct easy-to-digest comparison of cash, equities, bonds and real estate. Though the analysis is UK-specific, it can be safely applied to Indian markets as well.

Indian markets – Historical performance

So how has the Indian market done historically? Chart shows annual returns over the last 20 years for the two benchmark indices; the CNX Nifty, formerly S&P CNX Nifty and the BSE Sensex. The Sensex tracks the 30 largest companies by market capitalization while the Nifty tracks 50 largest companies across sectors. To refine that statement, both indices are in fact free-float market-weighted which means they exclude the proportion of market cap of companies that are owned by promoters and other investors with controlling interest in deciding the constituents.

What historical index returns show:

  • Indian equity market returns, like most other markets, have been volatile, with large swings year-on-year. That said, there have been more up years than down
  • There have been larger positive returns than there have been negative returns. Six of the last 20 years provided returns in the vicinity of +40% while only 2008 shows a negative return less than -40%
  • ₹1 invested on Dec 31 1993, 20 years later, would be worth ₹4.71 in the Nifty and ₹6.10 in the Sensex, translating to compound annual return of 8.06% and 9.47% respectively. Add to that the dividend yield of between 1% and 2% per year
  • Compare that to ₹1 put into 1 year Fixed Deposits (FD) and renewed at the prevailing rates each year. Unadjusted, the initial investment would be worth, ₹4.71, not far below the Nifty if you don’t consider dividends, also without all the intervening drama. However, since the marginal tax rate of 30% takes a sizable chunk out of the returns, the ending value is in fact ₹2.99

What historical index returns do NOT show:

  • Index returns do not show dividends that typically add between 1% and 3% depending on how expensive stocks are in a given year
  • Intra-year volatility that translates to the annual returns
  • Variation in performance of individual stocks within the indices
  • Divergence in performance of sectoral indices from the benchmark and of small and mid-cap stocks that do not qualify for the two indices

The takeaway from two decades of benchmark index data is that equities as an asset class provide significant returns albeit with significant amount of volatility in the short term but a reasonable amount of assurance in the long term

Over the long term, equities are low-risk

The final chart to consider the case for investing in equities shows how often rolling returns were negative when considering different time horizons.

When considered over 1 year durations, the Nifty and Sensex showed negative returns six and five times in 20 years. Increasing the horizon from 1 year to 3 years rolling (meaning 1994 – 1996, 1995 – 1997…) brings the instances down to five and four respectively. Once you take a seven-year horizon, only once were the returns negative and never over a 10 year period.

Irrespective of when one invests in the market, the chances of making positive returns increase significantly once the time horizon goes up above five years

In addition to these, there are a few additional advantages that make equity investing worth the time and effort for young investors just starting who are a few years in to their careers:

Small ticket size

Equities are accessible, irrespective of the size of your surplus fund. Investors can buy shares of investment-worthy companies for the price of a medium pizza from the local fast-food outlet

Diversification

The small ticket size also means investors can buy into various companies and sectors which serve to reduce, though not eliminate the overall risk of simultaneous decline in value

Real-time Learning

Publicly traded stocks have frequently updated and publicly available prices which allows the investor to track her investment over the holding period to build their own understanding of what drives stock prices, which not infrequently, is apparently nothing!

For the liquidity, longer term risk profile and the continuous learning opportunities, equities are must-have for almost any investor at the start or middle of her career.

References (external links):

Why stocks beat gold and bonds (CNN Money)

Over the long term, SENSEX is a bond (Mint)

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