Equity as an asset class #3 – Understanding stock market returns

So far we have understood what stocks are and how they are traded in the stock exchanges. In this post we will try and understand the characteristics of stock market returns. As usual I have drawn upon several sources of publicly available information to illustrate some of my observations. You may want to read more of these on the internet.

The most important thing to understand about stock market returns is that they are non-linear in nature. 

What do I mean by the above? If you take a fixed income instrument like FD or PPF then you are getting an assured return, may be differing by a few basis points due to interest rate changes. The age old principle of compounding works well with these products and you are able to predict the end result with some degree of accuracy. For example, the amount in an FD will keep growing till it attains maturity. The same is true for PPF and several other Debt mutual fund variants such as FMP, Liquid funds etc.

Non-linear return means there is no real predictability to the return, in fact you cannot even really say whether the return will be positive or negative. Obviously in the case of negative return you are going to suffer a loss in capital which can be rather stressful. So with all these risks inherent in equity as an asset class, why should we invest in it? The answer to this question lies in the ability of equities to outperform every other asset class over a longer period. It is also the only asset class which provides a meaningful hedge against inflation.

Let us look at some data points between 1980 and 2014 to understand this a little better.

• 1 lac invested in FD, Gold, Silver and Sensex would have become 16.94 lacs, 36.51 lacs, 28.39 lacs and 2.23 crores respectively. The Sensex returns are considered without the dividend yields.
• CAGR for the different options were 8,41%, 10.82%, 10.03% and 16.72% respectively.
• Inflation over the 35 year period has meant that purchasing power of 6 Rs in 1980 id equivalent to purchasing power of 100 Rs today..
• Equity is the only asset class that has provided annualized Real returns ( inflation adjusted ) of more than 9 % without considering dividend yields and nearly 11 % with that consideration.

I think the above will convince even the hardest critics of equity that there is really no option for us but to consider it as an asset class to invest in for the long term. Let us now try to understand this a little more in terms of our markets. We will look at the Sensex data over the last 15 years between 2000 and 2014. The following are noteworthy observations:-

• With June as the base month in every year, if we look at 15 year rolling returns there are 4 instances of negative returns. This reduced to 1 instance with 13 years and 0 instance with 11 or lesser years.
• Loss probability calculated on this data is 27 % for 1 year investment, 8 % for 3 years investment and nil thereafter. This means that if you are investing in equity over a period of 5 years or more in the Indian markets, the chances of actually losing money is quite low.
• The average return ranges between 13 and 17 %, whereas the median return ranges between 10 and 18 % for periods of 1 year to 15 years.
• The minimum returns range is between -30 % to 14 % and the maximum return range is between 13 % to 50 % for the same time period.
• Standard deviation range for the said period is between 0 % and 23 %. This obviously reduces as the time period is increased, getting to 0 in 15 years.

So the longer you remain invested in equities the lower is the probability of loss, the lower is the volatility of returns and the higher is the likelihood of getting predictable returns.

Now does this mean that equity should not be used for periods less than 10 years and will always work out to be great for period of 15 years or more? Though many people will tell you so, that is completely flawed logic. I will try and explain more on this in my next post.