The case for equity investment

Why buy equity? Many individuals who have lost money on the share market in the period after late 1994 have decided to avoid equity investment. Is that justified? If equity investment is useful, how should retail investors harness the gains with minimum pain?

We should first distinguish speculation from investment. Speculators make bets on the securities which they think will yield good returns. Speculators can earn spectacular profits, if the forecasts are correct. The reality, however, is that forecasting stock prices is extremely difficult. In a world where lakhs of intelligent people continually scan financial markets looking to profit from mispriced securities, speculative profits are extremely hard to obtain. At the same time, whether speculators earn profits or not, they suffer the steady bleed of transactions costs. Hence speculative trading is rarely useful for retail investors.

We will, instead, focus upon the investment objective. This does not require active trading. Many individuals who have suffered losses in speculation have concluded that investment in shares is inadvisable. This conclusion is incorrect. Economic research has revealed the benefits of investing in shares as clearly as it has revealed the difficulties of obtaining speculative profits.

What alternatives does an investor face? Instead of buying shares, investors can always place their money in a bank or in bonds. These instruments offer near--assured returns: their rate of return does not fluctuate much from month to month. In contrast, the value of every equity portfolio fluctuates in synchrony with the market index from month to month. Investing in the equity market imposes pain upon investors owing to month--to--month fluctuations in the index.

These fluctuations are the risk of equity investments. They have to be matched by higher returns in the equity market, on average. If there was an economy in which banks gave the same average returns as shares, there would be a stampede of investors selling off their shares and moving their money into bank accounts! In the process, share prices would fall, and at the lower prices, shares would once again be attractive, offering higher prospective returns.

The key is to focus on average returns, over long time--periods, on well diversified equity portfolios. Bets made on individual stocks are extremely risky, and there is no reward for bearing such risks. However, when we consider equity as a class, every economy in the world yields higher average returns on shares than on fixed return investments.

The excess surplus returns that shares yield, as compared with riskless alternatives, is called the equity premium. In every economy in the world, over every long time--period studied, there is a strong equity premium. Jeremy Siegel has written a marvellous book on these issues, titled Stocks for the Long Run (Irwin, 1994). The equity premium is the reward for investors who are willing to endure the day to day fluctuations of stock prices. There are year to year fluctuations in the stock market, but the average returns on stocks over long time periods turn out to be much higher than fixed return alternatives.

Inflation 4% Riskless real rate of return 6% Riskless nominal rate of return 10% Equity premium 8-10 percent points Nominal return on market index 18-20% Average time to doubling At riskless around 7 years In equity around 4 years

This table makes guesses about rates of return in the future in India. These are different from our historical experience in a high inflation environment. We assume that inflation in India will be around 4%, and the riskless rate of return will be 10% (i.e. 6% in real terms). This gives us fixed return investments which double each 7 years.

The equity premium in India lies between 8 and 10 percentage points (similar values are observed in many other countries). This gives a prospective long--run average rate of return on stocks between 18% and 20%, assuming reinvestment of dividends. These scenarios feature equity investments doubling each 4 years or so (on average).

Over long time--spans, the power of compound interest is profound. For example, let us use a 28--year holding period. Riskless investment yields a doubling of value in each 7 years (on average). A 28 year holding period contains 4 doublings at fixed returns -- converting Rs.1,000 into Rs.16,000. In the same period, equity investments would yield around 7 doublings (on average). A portfolio of Rs.1000 in equity would be worth around Rs.128,000 in 28 years.

The equity premium is effective on shorter horizons also. Using the observed volatility of the NSE-50 index, there is a 90% probability of stocks outperforming bonds on a five--year horizon.

Our main conclusions are: (a) investors are compensated for the pain of fluctuations in the stock market index by higher returns on average, and (b) over long time periods, the power of compounding makes equity investment enormously superior to fixed return investments.

How can one capture the equity premium? The equity premium is not about speculative profits, hence successful speculation is not required to harness it. The equity premium is not a reward for the risks taken in undiversified portfolios, hence there is no point in bearing such risks.

The equity premium accrues to all well diversified passive portfolios. The simplest example of a well diversified passive portfolio is the market index. Investors can accurately harness the equity premium by holding all the stocks of the NSE-50 index (in correct proportions). That is impractical for investors with small sums of money: in order to accurately buy the NSE-50 index, a minimum of Rs.30 lakh is required.

Hence, mutual funds have created index fund schemes. Index funds make no attempt to beat the market. They are focussed on capturing the equity premium for the investor. They passively purchase all the stocks of a market index, in correct proportions, and sit tight. In the process, they outperform around 75% of the actively managed funds.

Index funds are passive, and avoid the costs incurred in trading. Being low cost operations, they charge lower management fees. Investors can monitor the daily activities of the fund manager, by comparing the performance of the fund against the index. The fund should accurately track the returns of the index; a poorly run fund will suffer a large "tracking error". This degree of accountability of the fund manager is unique to index funds.

Index funds are thus the ideal vehicle through which individuals can harness the enormous long--run potential of equity investment. Internationally, index funds are the most important class of mutual fund schemes. For example, in the US, 40% of all professionally managed funds are in index funds.

The NSE-50 index is uniquely well suited for use in index funds. In early 1997, UTI created India's first index fund, the India Access Ltd., an offshore fund which tracks the NSE-50 index. SBI Mutual Fund will soon be launching a domestic index fund based on the NSE-50 index. The onset of index funds is a turning point for India's mutual fund industry. Index funds have the potential to deliver the benefits of equity investments to lakhs of retail investors, and help India's mutual fund industry to fulfil its potential.

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