Equity markets, by their very nature, are volatile. Stock prices, even of the best Companies, go up and come down all the time. The unending quest for the listed company that consistently generates a steady 20% p.a. return for investors on the back of an annual 25% plus growth in free cash flows to near-eternity and available at rock-bottom valuations can as well stop because there are no such companies. Fierce bull markets inevitably lead to steep corrections. The average investor’s attitude towards the market oscillates between “I am an investment genius and can do no wrong” during bull markets and “All is lost and I should vacate the market for good” during calamitous bear markets. It is not uncommon for a whole generation of investors to shun equities after a particularly painful investment experience and it is only the next bull market that attracts the next generation of investors. Ever since the second quarter of 2020, the allure for equities has fascinated a new breed of first-time young investors – those born in the eighties and till the mid-nineties or the so-called Millennials and Generation Z or those born after the mid-nineties – who do not know what a bear market looks like. It is therefore imperative that these first-time young investors understand the role of equities in building nest eggs for their old age.
No one, repeat no one, knows about the future with any degree of certainty despite the many business forecasts, earnings estimates and price targets that we routinely come across in scholarly equity research reports, as also the print and electronic media. What exactly do these forecasts, estimates and price targets involve? Whether these are based on technical or fundamental analyses, the analyst is simply saying that based on her judgement, understanding of past events and her expectations of how the future will unfold, her guestimate is that the stock price would go to the target price within a specified time frame. What needs to be emphasized is that none of the caveats – judgement, understanding of past events, expectations of the future and guestimate of target price – is sacrosanct and represents only one opinion among the many in the Street. The eventual reality may, and in fact quite frequently, turn out to be completely different. One should therefore be especially wary of the many talking-heads in the media who, without even batting an eyelid, keep prophesying about market levels and stock prices with an air of utter certainty and arrogance, as if the market has no other go than to move exactly as per their prophecies.
That said, equity investment is based on expectations of a potential appreciation in price. Equity prices are deemed to be discounting the underlying future free cash flows and hence in order to estimate the potential future price, we need to make some guesses about what the future holds for a Co. and how the future cash flows will stack up. A reflection on the past is a useful starting point for guessing about the future. Over the last 4 decades in India, inflation has averaged 7.1% whereas the most popular avenues for parking the savings of our citizens, viz. Bank FDs, Public Provident Fund and endowment policies of the Life Insurance Corporation of India have generated 8.7%, 9.6% and 5.2% respectively during the period. The other popular stores of value, Gold and Silver have generated 8.4% and 7.1% during the period. In real terms, that is net of inflation, Insurance has generated negative returns but has provided life cover to the insured, which is a huge social benefit. Among the other asset classes, silver has just matched inflation while Bank FD, PPF and Gold have generated 1.6%, 2.5% and 1.3% real returns. Contrast this with the Sensex – a basket of equity shares of 30 large companies – which has generated on an average around 14.8% returns, that is 7.7% in real terms, net of inflation.
The relative outperformance of equities, albeit at higher levels of risk, is not unique to India. The perspective from other countries is not much different and thankfully, we have market data of much older vintage. Over the past 120 years, diversified portfolios of equities in the US have generated a geometric mean annual return of around 6.6% and in the UK around 5.4%, whereas a similar investment in US and UK Bonds generated just about a 2% return. A dollar invested in the US equity market in 1900 would be now worth around US$2,291, whereas the same with US Bonds would be worth some US$12.50 today, while the numbers for the UK would be STG.572 and STG.10.40 respectively. There have been two world wars, nuclear bombing, the great depression, communist revolutions, hyper-inflation, the global financial meltdown, as also a few pandemics during the period, but these have affected both equity and bond markets. It is conceivable that the underlying dynamics of markets could change dramatically in the future and excess returns from equities might get pared down. It is useful to keep such possibilities in mind but other than moderating return expectations, there is no justifiable basis to come to reasonable conclusions about potential returns on this premise. There is also the case made by compulsive doomsayers that the human race could become extinct because of say, nuclear destruction or climate change etc. but then there is no point in discussing future investment returns.
Whether such a stark divergence between the end-of-period values over the last 120 years in equities vis-à-vis bonds can be explained simply in terms of equity risk premiums – as is the long-held belief in finance theory – is certainly debatable but that is for another day. Investment experience over the last more than a century has demonstrated that while equity prices wax and wane all the time, over the long term they are mean-reverting. This can be seen in any long term trend line of broad-based equity indices where there are many kinks in the graph over the short term with possibly several periods of low returns but a secular upward sloping graph in the medium to long term. The long-term systematic investor can take solace from the not-too-well-known fact that even if she was specifically unlucky to have invested in the Sensex basket only at every significant market high over the last 20 years, she would still have clocked a compounded annualised return of around 9% over the period. The logical inference from all this is simply that there is no escape from equities to build a nest egg. Fixed Income investment leads one to nearly guaranteed under-performance if the objective is to build a nest egg for the long term. To revert to the army of the first-time Millennial and Generation Z investors in the equity markets, the lesson from all this is not to be perpetually scared of the mother-of-all-bear markets ahead in equities but to take moderate and affordable risks while investing in equity baskets as a part of their chosen asset allocation. While generating Warren Buffet like returns could be the objective, prudent and well-advised equity investing can most likely generate the required returns to build the sought-after nest egg for old age despite the vicissitudes of the market.
This article is authored by UR Bhat, Co-Founder at Alphaniti (www.alphaniti.com)
Thank you for reading this post, don't forget to subscribe!