Long-term equity returns: Claim vs reality

Overarching claims, disclaimers give rise to wrong expectations about risk and return to the investor

When on August 1, 2017, Nifty 50 touched 10,114, it gave a return (theoretical) of over 32x in approximately 27 years. While Nifty 50 was launched for trading on April 1996, it was back calculated all the way to July 20, 1990, for the purpose of index creation. From July 20, 1990, till date, Nifty 50 has given an annualised return of approximately 13.7 per cent. While such headlines create a case for long-term investment in Indian equities, it also sets wrong expectations about risk and return among retail investors. It is surprising that the market regulator feels that an overarching disclaimer, that is, “equity markets are subject to market risks” is sufficient sensitisation to investors about this risk. It’s worrisome that some entities regulated by the Securities and Exchange Board of India get away by claiming that equity markets gave 15 per cent return by choosing specific base years; arguably such claims may be misleading the retail investor.

From the launch date of Nifty 50 the current level suggests an 8.7x growth with annualised returns (including dividend) of approximately 11 per cent. Note that a change in base year for returns calculation (from 1990 to 1996) reduces annualised returns significantly.

The layman investor often concludes that:

* In the past five- to 10-year holding period (or even longer) the market has given handsome returns, enough to justify the “market risk”.

* The returns were well above rates of bank deposits or investment in bonds. The retail investor takes investment decisions based on an over-simplistic understanding of past returns of Indian equity. However, this understanding sometimes sets up the investor for shocks. This understanding is driven by advertisements bombarding them with overarching headlines, which hide nuances of historical return.

The bulk of the returns in the last 27 years happened in two stretches. One, between 1990 and 1992; the other between July 2003 and January 2008. However, the 11-year period between 1992 and 2003 and then again from January 2008 to August 2013, the long-term growth has been largely flat to negative.

There are two typical ways in which equity returns are calculated for public consumption. One is the way (see Nifty 50 graph alongside) where index values at the start and end of a multi-year period are used to calculate the cumulative return and then annualised using compounding returns. Mutual funds, while highlighting their performance, often take returns between specific dates such as April 1 as start date and March 31 as end date after one or multiple years. Then the annualised returns calculated from these very similar approaches are used to present the annual return an investor may expect for a long-term holding period.

While this method is not incorrect, it ignores a practical aspect of investment behaviour. An investor will invest on any day and likewise sell on any day, subject to markets being open for trading. Thus, it may be argued that the one, five and 10-year returns be calculated on a rolling basis and then the median or average returns be taken. This may be more representative of the “true” return. This approach also shows the variation of returns for each of these holding periods, preparing investors for negative return even for five- or 10-year holding periods.

As the table shows, the last 27 years’ returns suggest that in one out of 10 instances, a five-year holding period exhibited a cumulative return (not annualised) of two per cent and, if dividend is included, then five per cent. There were 10-year investment holding periods where cumulative returns were less than 48 per cent, which is the same as a four per cent return of savings account. The retail investor must realise upfront that there are stretches of five years or 10 years where equity returns barely beat the bank savings deposit.

 

Sebi can do well to persuade its regulated entities to elucidate to retail investors the true nature of the market risk by sharing not just the average/median returns but also the variances in returns. 

Additionally, mutual funds must be mandated to calculate their return of rolling basis. Retail investors deserve to be communicated in simple language that median annualised returns for five-year and 10-year holding period ranges from nine per cent to 13 per cent. But there were instances where even a 10-year holding period had flat returns and stretches where five-year returns yielded negative return.

Investors who invest after knowing these divergences in long-term return, truly exhibit the appetite for handling equity market risks and will lend to long-term stability of the market. This is clearly what Sebi will also want since misguided and disillusioned retail investors cannot form the basis for a deep, sustainable market.

The author is a financial services professional and visiting faculty of finance, IIM Calcutta 

A version of this article appeared in Artha, an IIM Calcutta magazine