Asset managers worry about the composition of their investment portfolios, that is, the proportions of stocks, bonds and cash in their holdings. This article is aimed at sensitising retail investors in India about the risks involved in investing in stocks vis-à-vis fixed income securities.
Various empirical studies indicate that returns from long-term investments in equity indices are higher than returns from risk-free government debt. However, over the last 100 years, there have been patches of a decade or longer when diversified equity portfolios have yielded lower returns than Treasury bills/bonds. Individual investors are tempted to make equity investments after a period of rising stock valuations and they get burnt once markets inevitably correct sharply downwards.
Asset managers draw the attention of retail investors to the “equity risk premium” in advising them to invest in stocks over the long term. However, the risks involved are usually not explained. Equity risk premium is the higher return, over an adequately long investment period, which can be expected from investing in a balanced portfolio of stocks as compared to short-term, risk-free benchmarks such as Treasury bills (Treasury bonds carry market risk, i.e. interest rate risk unless held to maturity). If stock market returns were to be compared to sovereign bonds, the equity risk premium would be lower as government bond yield curves are usually upward-sloping, reflecting the liquidity premium which has to be paid to issue longer maturity fixed income securities.
The nominal and real returns in the last 20 years on stocks and sovereign bond indices (remaining maturities one to 10 years) in the US, the UK, Germany and Japan are shown in the table. These four G7 countries were chosen since they are currently rated AAA.
In the 10 years from 1990 to 2000, while equity markets in the US, the UK and Germany were up in real terms, the Japanese stock market was down by 63 per cent. In the last 10 years from 2000 to 2010, the stock markets in all four countries have provided negative returns and have performed poorly compared to sovereign bonds. A London School of Business study by Elroy Dimson, Paul Marsh and Mike Staunton (referred to in the Economist of September 4, 2010 and available at ssrn.com/abstract=891620) uses a database of “long-run stock, bond, bill, inflation and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval”. This study finds that “taking US Treasury bills as risk-free, the annualised risk premium for the world index was 4.7 per cent”. Although different conclusions could be drawn on the size of the equity risk premium, depending on the country and the evaluation period chosen, there have been periods when such a premium has persisted compared to short maturity sovereign Treasury bills.
In G7 countries, growth projections and demographics point towards relatively bleak prospects for equity markets over the next 10 years. Concurrently, US, German and Japanese sovereign debt yields are likely to remain at historic lows. The post-Second World War baby-boomers will probably invest less and consume more in their twilight years. Perhaps some of this pessimism is reflected in EPFR Global Data’s findings that in calendar year 2010, there have been net outflows of $30.3 billion from US equity funds and $11.6 billion from European stock funds. All this has to be a cause for concern in asset allocation decisions in G20 countries, including India.
| FACT SHEET | ||||||||
| EQUITY INDEX@ | GOVERNMENT BOND INDEX@ | |||||||
| Dow | FTSE | Dax | Nikkei | US | UK | Germany | Japan | |
| 31/1/1990 | ||||||||
| Nominal | 2591 | 2337 | 1823 | 37189 | 123 | 149 | 126 | 119 |
| Real* | 4408 | 4260 | n/a | 40474 | 209 | 272 | n/a | 129 |
| 31/1/1995 | ||||||||
| Nominal | 4244 | 3303 | 2235 | 20591 | 182 | 252 | 209 | 252 |
| Real | 6117 | 4926 | 2764 | 20397 | 263 | 376 | 259 | 249 |
| 31/1/2000 | ||||||||
| Nominal | 13337 | 7641 | 8333 | 23819 | 256 | 425 | 223 | 319 |
| Real | 17125 | 9987 | 9669 | 23214 | 329 | 555 | 258 | 311 |
| 31/1/2005 | ||||||||
| Nominal | 14118 | 6530 | 5726 | 15326 | 370 | 666 | 414 | 363 |
| Real | 16042 | 7530 | 6199 | 15219 | 420 | 768 | 449 | 361 |
| 31/1/2010 | ||||||||
| Nominal | 14959 | 7710 | 8334 | 15153 | 472 | 728 | 542 | 447 |
| Real | 14959 | 7710 | 8334 | 15153 | 472 | 728 | 542 | 447 |
| @ Dividends are assumed to be reinvested and the average dividend yield on stocks is assumed to be 2% per annum. Coupon payments on bonds are also assumed to be reinvested. * "Real" prices are as of 2010. Source for underlying numbers: Barclays Capital | ||||||||
Turning to the performance of equity markets in India, real stock market returns were positive in the last 20 years. For instance, the real return on the Nifty — assuming dividends were reinvested and the dividend yield was 1.5 per cent per annum — was about 42 per cent in the nine-year period from September 1991 to September 2000. Similarly, the real return from September 2000 to September 2010 was 129 per cent. The Indian rupee 91-day Treasury bill yield was 6.14 per cent as of September 15, 2010. Assuming a Treasury bill yield of this level for the last 10 years, the equity risk premium in India from 2000-2010 was about 4 per cent.
The standard advice to retail investors is to hold their portfolio of stocks for at least five-ten years and not try to be day traders. For older investors, the preference could be to hold more bank deposits choosing regular interest income to future growth. In practice, in 2008-09, Indian investments out of household savings in financial assets were as follows. About 8.2 per cent of GDP was invested in deposits as compared to 0.4 per cent in shares and debentures and 2.8 per cent in insurance funds. The 0.4 per cent of GDP investment in shares and debentures was after the global downturn and the average from 1994 to 2009 was around 1.6 per cent. (Source: RBI Annual Reports.)
India’s growth prospects are bright, its demographics are right and its stock markets have risen sharply in the first few days of this week. However, India’s financial markets cannot be decoupled from G7 economies and Indian stocks are frothy in terms of price-to-earnings (P/E) levels which are well above 20. One of the reasons for the financial sector meltdown in 2008 was that regulators and macroeconomists were not mindful of the extravagant risks taken by financial intermediaries. On the flip side, going forward Indian capital market participants should be careful to closely follow macroeconomic developments, including the risks associated with sovereign debt rescheduling or even default among developed countries with relatively high credit ratings.
The author is India’s ambassador to the European Union, Belgium and Luxembourg. The views expressed are personal
