The general perception is that Equity investments belong to the riskiest class of assets and you need to be a huge risk taker to be invested in Equities. This perception among investors is not without reason. Many individuals who have lost money in the share market during various market crashes in 1992-93, 2000-01 and most recently during the global financial crises of 2008 have decided to avoid equity investment in totality. Is that justified? If equity investment generates superior returns, how should retail investors harness the gains with minimum pain?
We should first distinguish speculation from investment. Speculators make bets on the securities, which they think will yield good returns. Speculators can earn spectacular profits, if the forecasts are correct. The reality, however, is that forecasting short term stock prices is extremely difficult. In a world where lakhs of intelligent people continually scan financial markets looking to profit from mis-priced securities, speculative profits are extremely hard to obtain. At the same time, whether speculators earn profits or not, they suffer the steady bleed of transactions costs. Hence speculative trading is rarely a gainful activity for retail investors.
Retail investors should instead focus on long term investing. This does not require active trading. Statistical findings have shown that though there may be month-to-month fluctuations in the equity index, over long periods of time, say 15 – 20 years, these fluctuations get evened out, and steady higher- than-average returns are delivered by the equity markets.
In the table given below, in Annexure 1 the rolling returns of the BSE Sensex has been listed on a 1 year, 3 year, 5 year, 7 year, 10 year and a 15 year period. If you look at the 1-year rolling return you will see that the probability of loosing the principal invested is 11 out of 30. The probability of loss decreases to 3 out of 24 for a 7 year holding period, 1 out of 21 for a 10 year holding period and 0 out of 16 for a 15 year holding period. The mean return decreases as well, as the holding period increases, from 25.4% for a holding period of 1 year to 16.8% for a holding period of 15 years. The Standard Deviation, which is a measure of risk, falls from a high of 56% for a 1-year holding period to 5% for a 15-year holding period.
The inference that we can draw from these data are :
- For investment in shares, risk diminishes as the holding period increases
- Over a long investment period such as 10 or 15 years the expected returns from equities outperform those on fixed income securities.
- Indian Capital Markets have delivered mean returns of around 16% which leads to wealth creation as explained in note on “Wealth Creation Demystified”.
- These returns were earned when the country grew by 4%. The forecasts are that country will grow by 6% over the next 20 years.
It is for this reason that globally the major investors in the stock market are pension funds and Insurance Companies whose investment horizon is long. They can thus earn superior returns and harness the power of compounding to generate substantial wealth for their investors.
– Alistair Noronha –
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