Equity MFs are too risky with no guarantees why should I invest in them?

Published: November 4, 2020 at 1:22 pm

Last Updated on November 4, 2020 at 1:26 pm

Each time we point out that Sensex or Nifty returns have reduced considerably over the last decade and caution investors to lower expectations, there are always a few comments that go, “why to invest in equity or equity mutual funds if there is no guarantee of returns? The risk of investing for a long time only to find out the returns are lower than PPF or FD is too high”. In this article, we discuss if it still makes sense to invest in equity mutual funds.

Risk is the only guarantee associated with equity.  Sadly those who want “business” from regular plan MF or direct plan MF tell people that we stay invested the risk will reduce.  In our recent article, we discussed how the last decade was relatively ‘quiet’ for the Sensex with not as many big up or down moves: Sensex return is 16% plus over last 41 years but half of that came from just three good years!

As a result, overall returns had also come down: Ten-year Nifty SIP returns have reduced by almost 50%. The grim reality of the equity market is,  for big returns, we need big volatility and big losses. They are joined at the hip. We will have to change our mindset from viewing risk as “bad” and welcome it as an opportunity.

Imagine travelling standing on a crowded train. If no one got up, then your position will never change. However, if people get up from time to time, you have your opportunity  (not guarantee) to sit; There could be long periods of no opportunity. Unless our station is coming soon we do not have to give up hope; There could be a mass exit; Do we also get out or find a spot to sit?

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It is a crude example, but the point is, when you are given an opportunity to change your station in life (eg. from standing to sitting), you will have to accept the fact that such opportunities will require at least patience.

Equity investing is a choice; a chance. That is all. It depends on when you started investing, also known as timing luck. If someone had started investing in the early 2000s and had the determination and patience to handle the 2008 financial crisis and the subsequent will to sit through the five-year range-bound market, their returns would be “good” (to say the least) even after the 2020 fall. It is unfair to call it timing “luck” but that is how it is.

So the question remains, “ok, returns are not guaranteed, but at least does the market provide opportunities regularly?” The truth is that it depends on the market. Take the S&P 500 TRI for instance.

For a US resident who invested in 1st Jan 1988, the return as of 1st Jan 2020 would be 10.64%. Considering US inflation at 3-5%, this is an acceptable return. The INR-USD exchange rate is irrelevant to our discussion.

Over these 33 years, the investor would have witnessed 23 annual returns greater than 5% and only seven negative annual returns. This may seem like a great deal but those were big down moves:

  • -38.63% 01-01-2009 (return from 1st Jan 2008 to 1st Jan 2009)
  • -23.02% 01-01-2003
  • -16.15% 01-01-2002
  • -2.31% 01-01-2019
  • -2.31% 01-01-2008
  • -0.90% 01-01-2001
  • -0.67% 01-01-2016

These negative returns though fewer almost perfectly balance out the gains. If we remove these top three positive returns:

  • 38.66% 01-01-1996
  • 34.57% 01-01-2004
  • 33.14% 01-01-2010

The 33-year CAGR drops from 10.64% to 7.54%. If we remove the top-three negative returns, the CAGR increases from 10.64% to 13.89%.

The effect of removing the top-3 positive returns decreases the CAGR by 3.1% and the effect of removing the top-3 negative returns increases the CAGR by 3.25%. Thus the US market (large cap) is almost as risky as it is rewarding. The only reason a “long-term” investor has got a 10% return is due to the fact that the big positive returns are larger than than the falls. The top seven returns are above 26% while only two negative returns are below 23%. This is a well-known positive-skew in the stock market.

Before we discuss this positive-skew, let us do a similar exercise for the Sensex (price return; a dividend of 2% should be added). From April 1998 to April 2020 the 33-year CAGR for the Sensex price movement is 14.26%.

Remove the top-3 positive returns, the 33-year CAGR is 5.59% – a fall of 8.67%. Now remove the top-3 negative returns, the 33-Y CAGR is 19.54% – a jump of 5.28%. This is a significant disparity.

The reason for this is easy to spot. The highest annual return for the S& P 500 is 38.66%. The lowest is -38.63%, almost symmetric (but these returns occurred in different points in time). For the Sensex, the corresponding numbers are, 268% and -47% which occurred in subsequent years.

The point is, the market shot up 268% largely due to scam but corrected only 47% and the year after that moved up again by 63%. Has this disparity decreased over the 20 years?

The last 20Y price CAGR for the Sensex is 8.99% (before dividends). Remove the top-3 annual returns the CAGR drops to -0.21% a fall of 9.2%. Remove the bottom-3 annual returns the CAGR becomes 15.59% a jump of 6.3%. Even if we remove the Harshad Mehta scam (can we?) the skew towards positive returns remains. Perhaps this is because of an emerging economy?

Both markets have provided ample oppurtunities to the patient, disciplined investor.

Why is there a positive skew? In my opinion*, it stems from a collective belief in the market (rational or otherwise). If we ask, “where does the Sunrise?”, the answer is “East” (ignoring solstice!). If we ask, “why does the sunrise in the East?”, the answer is, “because we say it is so”. If 7/10 people decide to call the sunrise direction as East then East it is. * I am sure there is a ton of research on this, but I have no motivation to read this.

They may doubt about call it East from time to time but quickly decide to brush aside their doubts. With respect to the market, there are temporary doubts about its immediate future (resulting in crashes) but since humans search for positivity in a situation, there is an eventual recovery. The belief in the market gets tested from time to time but it manages to stay afloat due to human nature.

Gold, on the other hand, zooms up when there is fear and gloom, but again because of our survival instincts, the gloom fades sooner than later. No guarantees of “good returns”, no guarantees of “beating inflation”. The market offers us a chance. A chance is all we get. How we choose to exploit it, is up to us. How we choose to manage this risk determines our station in life.

Crashes, recoveries, years and years of range-bound movement, these are all oppurtunities for reward as well as risk. The solution is not to stay put.

Staying investing no matter what for the long-term is not a smart strategy (as the sellers would have us believe). It is leaving the fate of our hard money in the hands of luck. Surely our hard-earned money deserves better respect?! See: Will long-term equity investing always be successful?

So what is the solution? Invest regularly with a goal in mind. Invest in equity only if you have enough time in hand – that big return needs patience; At the very least rebalance your portfolio regularly and preserve those gains. See a detailed example here: What is profit booking in mutual funds?

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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