Why Equities give best returns in the long run; but with caveats…

As the Sensex and the Nifty gyrate to the tunes of market triggers like quarterly earnings, RBI guidance and the Fed moves, it is time to sit back and ask a simple question. Do equities actually give the best returns among asset classes in the long term? When spoken about in a global context, the experience may not always bear out. For example, during the last 20 year period, bonds and index funds have actually given as much returns as smart equities. In countries like India, real estate in many states has substantially outperformed equities, although that market is less liquid and organized compared to equities. Then, gold during its frenzied phases like 1971-1979 or 2009-2011 have managed to outperform equity as an asset class. In the Indian context, there is a strong case why equities will actually outperform other asset classes over the long term.

Let us take the case of the Sensex from 1981 onwards. Over the last 34 years, it has returned on an average, 18% annualised. This is easily higher than other asset classes. Nifty, which was added in 1994, has also returned over 23% over the last 20 years. Of course if you add up the dividends it would be a couple of percentage points higher. The second thing about these returns is that they are entry-agnostic. In fact if you had invested in the Sensex at any point of time irrespective of levels, you would have made a minimum return of 15% till date.

Power of compounding works best in India…

You have an equity market with a plethora of quality mid-cap and small-cap companies, pedigreed large cap companies, GDP growth rate of 7.5-8%, low inflation and lowering interest rates and you have all the ingredients of a high return equity market. It is a combination of the above factors that actually helps the power of compounding to work best in the Indian context. A quick study of the Nifty indicates that under-1 year, the returns are mostly negligible. If stocks are held for 4-5 years then in most cases it results in doubling of money. Similarly, when the holding period is extended to 10 years then there is a very high chance of tripling your money on the Nifty. So the message is; buy good equity funds and sit tight without worrying about the vagaries of the market. The markets will do the job for you.

It eventually boils down to probabilities…

Longer the holding period, higher the probability of gains! That is the essence while valuing options. Option intrinsic values typically tend to be positively related to time because more the time to expiry, greater the probability of the price moving in favour. At the end of the day, an equity stock is an option on the tangible and intangible assets of the firm. A long time frame gives assets more time to work and generate wealth for the company. Take the case of Infosys in the 1980s and 1990s. While the business model had been established by the late eighties, it took another 8 years by the time the model could be scaled up, profitability could be sustained and market value could be created. The moral of the story, therefore, is, “A longer holding period ensures that the probability of gains are higher”.

For a portfolio of stocks, a longer time frame ensures two things. Firstly, a longer time frame ensures that the leaders within the portfolio get the time to perform and translate their performance into stock market returns. Secondly, a longer time frame also ensures that the laggards have a chance to either start performing or the fund manager has the option to cut risk by removing such stocks from the portfolio. Either ways, it enhances portfolio returns in the long run.

Watch for the global experience…

In most developed markets, equities have not been the best performing asset class over the longer term. This is because most of these economies lack the two basis ingredients that Indian markets offer; a combination of high GDP growth and falling interest rates. Take the case of the UK. According to a Barclays report, an investment in property returned 132% during the period 2000-2014. In contrast, equities only returned 83% during the same period, and that too after considering dividend re-investment which is an impractical assumption in most cases. Even in the US, the sharp correction in 2007-2008, made the rally post 2009 look frenetic. Otherwise, the NASDAQ today is lower than the peak touched in 2000, even after a full 15 years. About the Japanese market’s lost decades since 1989, the less said the better.

To cut a long story short, equities will outperform, but the effect will be restricted to a handful of economies like India which offer the unique combination of high GDP growth and falling interest rates.

So Indian equities will outperform, but with caveats…

On a broad and diversified basis, there is a very high probability that Indian equities will outperform over the longer period (over 7 years). However, there are a few caveats. Firstly, buying a portfolio of frothy stocks at the peak of frenzy is not a great idea. Buying tech stocks in 2000 or real estate stocks in 2007 or capital goods in 2010, are not great ideas. The concentration risk is just too high. Secondly, there has to be a constant process of review and revitalization of the portfolio. This includes removing the laggards, re-allocating to winners and consolidating on returns. These can be best achieved by a high quality equity mutual fund with a great track record.

The message for investors is clear. Focus on quality equities as the preferred asset class, use a quality fund management vehicle to participate, avoid outlier investing and stay put for the long term. As long as you are in Indian equities, you are poised to outperform other asset classes!

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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