Equities are the best investment for the long term! This is a common belief amongst many investors in the stock markets. In this blog, I am doing a critical examination of this belief. Interestingly the conclusion that I have come to is that equities may not always be the best bet in the long term!
What does long term really mean?
I am sure this thought has crossed your mind several times and you would have either reflected on this question or sought answers from investment experts. You can get a lot of different answers to this question. Some experts believe that a 3 years to 5 years is a good enough investment horizon, while some believe that you should have an investment outlook of at least 10 years. Of course, there are a few who believe that the investment time frame should be well beyond 10 years. In this blog, all I am trying to evaluate is the results that have been delivered in the indian stock markets over the last 3, 5, 10, 15, 20…40 years.
Does index investing really work?
The BSE Sensex and Nifty 50 are two popular stock market indices in India. Most investors believe that index funds can deliver significantly higher returns over the long term. This is due to the fact that these funds buy into blue chip stocks and the expense ratio too for index funds is very low. But does index investing really work?
The BSE Sensex has grown from a base level of 100 (Base Year 1979-80) to over 34,000 now (a growth of 34 times in 40 years). This translates to an investment return of over 15% p.a. over the last 40 years. If you had exited at 40,000 plus index levels, the investment returns would be over 16% p.a. – who can argue against such high returns? Prima facie, it seems that index investing works in the long run.
However, when we observe the investment returns that were delivered in each of the 4 decades, there is an interesting pattern that comes through. The table below shows the decade-wise returns of the BSE Sensex.
The returns have dropped over the last four decades. The returns generated in the last decade by investing in index funds is almost one half of the returns generated in the 1980s or 1990s. A big reason for this is that India has moved away from the high inflationary times of the 1980s and 1990s to an era where the inflation rate has dropped below 6% per annum, The Reserve Bank of India now has inflation management at the core of its monetary policy.
Refer table below. You may be surprised to see the trailing returns of the BSE Sensex over the last 20 years. It is nowhere close to the 15% plus return delivered by the index over the last 40 years.
We need to build realistic expectation of investment returns specially when inflation rates are at their lowest levels not only in India but across the globe. It is unlikely that the equity returns as represented by the large cap indices will deliver a double digit return over the next decade or two, unless inflation makes a strong comeback.
Several investors participate in the equity markets through actively managed mutual funds. The belief is that these funds would help generate higher returns than what has been delivered by the large cap indices. The bulk of the investments in the equity funds are in multi cap or large cap funds.
Investors invest in debt funds as well. Debt Funds do not take any exposure to the stock market and invest primarily in fixed income securities. Liquid funds are very popular with investors too as several investors do not want to take any risk with their investments while parking funds for a very short term investment horizon. One of the categories in debt funds is the gilt funds. As the name suggests, these funds invest only into government securities.
The table below illustrates the investment performance of the above categories of mutual funds.
As you would notice from the table above, the investment returns from investing in equities over the last 10 years have not yielded great results. The BSE Sensex has delivered a CAGR of 7.1% and even SIP returns over the same period are at 7%. Gilt funds with a 10 year constant maturity have delivered returns of 9.3% which is higher than the BSE Sensex.
Interestingly, the mid cap and small cap category has delivered significantly higher returns than the large cap funds over a 10 year period.
Conclusion
I would like to highlight four important conclusions from the above analysis.
First, investing into index funds may not be the best bet in the long term. An element of timing also matters, though it may not be easy to time the markets. Maybe you need to be a little more lucky!
Second, there are several segments of the stock market that can potentially deliver higher returns than large cap stock indices. The mid cap and small cap funds and a few sectoral/thematic funds have managed to deliver higher returns as compared to the BSE Sensex in the long run.
Third, we need to build realistic expectations of investment returns from the stock markets. If we base our investments on only past experience we are likely to falter. Investment returns were high from equities also due to the fact that the country had very high levels of inflation in the 1980s and 1990s. We have not changed our assumptions about the future investment returns though the economic environment has changed significantly.
Last but not the least, asset allocation is what really matters. Investors should be thinking in terms of overall portfolios instead of individual funds or stocks. Debt too has a significant role to play in your portfolio. It can be tactically used to enhance investment returns while at the same time providing a cushion as well as liquidity during tough times.
I am concluding this blog with some links that can help you do some more analysis on investment performances on point to point and SIP returns from investments in various funds. I encourage you to draw your own conclusions from this data and make suitable adjustments to you expectations and portfolios!
Fund Category Returns: https://www.valueresearchonline.com/funds/
SIP Returns: https://www.valueresearchonline.com/sip-return-calc/
