R Jagannathan: Equity is the only option

MICROVIEW

For much of the 1990s, most savers would have been better-off investing in long-term, risk-free avenues such as PPF, relief bonds, and post office schemes, instead of equity.

Canny investors may have made tons of money by picking the right stocks at the right time, but not the hoi polloi. In other words, equity did not really compensate long-term investors well enough to cover the risks involved""till last year's bull run changed the equations.

Starting from where we are now, I believe that the risk of not investing in equity is going to be higher than investing in it. The reason: I am pessimistic on interest rates, from a saver's point of view. The current headline inflation rate of 7.51 per cent may be overstating the underlying inflationary potential of the economy, but there is no denying that most fixed-rate instruments have gone under water. They offer negative real returns, especially after adjusting for taxes.

The bias against higher interest rates may well continue for a while. Three factors militate against the possibility of a rapid increase in interest rates: one, as the largest borrower, the government has a vested interest in lower rates; two, the RBI would like to protect bank balance-sheets as long as possible (a quick rate rise would reduce bank profitability); and three, the huge constituency of borrowers created by the extension of cheap retail loans will make politicians and policy-makers delay rate hikes till they become inevitable.

Assuming that administered rates will stay low, long-term savers have no option but to increase allocations to equity. This is the only way to beat inflation.

The pros will tell you that was always the case, but I don't think so. One of the great myths of stock investing is that you can beat fixed-income yields over the long term by staying invested in a diverse portfolio of stocks.

Another is that you must not try to time the markets. Both are bits of bad advice. The fact is: even if you can't time your entry very well""say, you started investing in February 2000""you must still time your exit well.

The right advice is commonsense: assuming you have invested in fundamentally sound stocks, or in an index fund, you would be foolish to stay invested all the time. You should book substantial profits whenever you are ahead of the game.

If you had invested in 1992 and 1994, when the Sensex crossed 4,600, there is no way you could have made money on the markets till 2000. But in 1999-00, if you did not partially book profits, staying invested would have lost you more money. So Rule 1 for ordinary investors: you must stay invested only as long as you have not made money. Once you have, you must move a part of your assets to non-equity avenues, to reduce risks.

For investors who don't have the stomach to take the risks themselves, mutual funds are an obvious option. Indian funds have mostly managed to outperform the markets in recent years. However, I don't believe that mutual funds will always beat the market. In the US, the vast majority of funds underperform the market, which is why many investors seek the relative safety of index funds.

The reason for underperformance is that most fund managers benchmark themselves against the main indices and each other; this means they all tend to chase the same well-researched stocks, and hedge themselves against gross underperformance by investing in similar ways.

The other reason why funds may not always do well is that the market is too shallow for them when they look beyond the top 80""100 high-volume stocks. Thus, the impact cost of a mutual fund buying or selling stocks is always greater than for high net worth or retail investors. This high impact cost automatically trims their potential gains. From this comes Rule 2: individual investors can, with some serious effort, outperform mutual funds because the market is always liquid for retail investors.

Which brings me to an important caveat: You can't obtain much higher returns from stocks""even over the long term""unless the volume of money coming into the markets is increasing. The boom of 2004 was almost entirely due to the entry of FII funds.

In the US, the secular growth in stocks over the last 20 years was the result of huge infusions of money from pension and mutual funds. But once these fund flows start reducing to normal levels, stockmarket growth will be more sedentary.

In India, pension fund money is still to enter the markets. When this begins to happen""I think it is only a matter of time""the markets will boom like never before. That's why I believe that staying out of equity now is riskier than before. Diversification into equity is the only answer even for normally risk-averse investors.

rjagann@business-standard.com