“Why should I invest in equity if it comes with no guarantees?!” A mighty fine question wouldn’t you say? In this post, I discuss the nature of stock market returns and why despite the lack of guarantees, it still a necessary investment avenue for some.
First of all, let me make it clear that I am not interested in increasing the equity participation in India simply because I gain nothing from it. I am not a salesman and would like to make it clear to everyone that equity investing is not necessary to beat inflation.
To understand the nature of the stock market and how to profit from it, at least two important ideas are necessary
- The risk premium and
- Sequence of returns
These ideas are illustrated below with two examples
The liquid fund NAV is something that will always increase! It buys bonds which mature within 91 days, profits from it, uses the (available) money and buys more bonds and so on. So the NAV will always increase quite smoothly.
Great! Now look at the annual returns from the same source.
That is not constant at all! Why? Becuase of market forces – demand, supply, liquidity which determines returns. Those who understand what the slope of a line refers to can see the trend in the NAV plot itself.
Moral: Even a security that appears to smoothly increase over a period of time can still be quite volatile in terms of returns.
Now, let us assume a risk-free instrument offering 6% return a year available to us.
So now we have a choice between choosing a risk-free rate of 6% or a market linked product (not a liquid fund) with the potential of earning more than 6%.
Therefore, we chose the market linked product with the hope of seeking risk premium – return above the risk-free rate.
The above table shows the annual return from the market linked product, the cagr for the corresponding investment duration. that is after 1,2,3,4,5, and 6 years.
Only in the 4 year was the annual return > 6%. A risk premium was available that year, but the overall 4Y CAGR is still only 5%.
The 5th year 10% return finally pushes the CAGR to 6% but it drops after the 6th year return is only 3%
This is a crude example and you can imgaine the impact if annual returns returns can be negative like equity.
- One cannot expect a reward for the risk taken each year. One many need to wait several years.
- And the reward obtained after a wait can be destroyed in a single market movement.
‘This’ is known as sequence of returns.
Now over this 6 years the (imaginary) market linked product has overall increased from a value of 100 (say) to 137.
However, the benefit it offers to an investor depends on the point of entry, the point of exit and the risk management done in-between. Broadly speaking, this is what “equity investing comes with no guarantees” means.
The central point of this post is, just because we expect the index to move up ‘over the long-term’ (hope) does not mean we will get ‘good returns’ (is not a strategy).
It is plain stupidity to assume that all one has to do is to start a monthly SIP and let it run for years and years and one will good inflation beating returns. If is such a sure thing, what is the difference between equity and a fixed deposit!!
Risk premium presupposes the existence of risk, which in turn implies the premium is uncertain to begin with.
To repeat something I keep saying, the corpus of a mutual fund SIP faces the full market risk. Only the next instalment is averaged (in terms of time and units).
A good sequence of returns can lead to spectacular risk premium and a poor one to disaster.
Wait a minute! Why should the (equity) index move up over the long-term? I have collected a wonder set of resources to investigate this – deserves a separate post.
Let us now try and answer the titular question: Why should I invest in equity if it comes with no guarantees?!
You don’t have to if
- fixed returns is all that you care about
- you can find some other instrument which has a reasonable chance of beating inflation. Many are convinced that real estate would do this. If you agree, so be it. Personally, I will never invest in real estate.
- you don’t have enough to invest either in real estate or in fixed income alone when realistic inflation is considered.
My response: I hate volatility as much as any man. When I started out, I did not have enough to plan my financial goals with fixed income. I value liquidity more than returns. So the only way out for me was/is to invest in equity and grapple with the risk premium and sequence of returns as best as I can.
I might fail, but that is a chance I had to take. Between certain failure (to beat inflation) with fixed income and a possibility of failure with equity, the choice is quite natural.
Once the choice is made, then the only option is to understand how best risk can be managed:
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