How does one — in this extremely depressing time for India as it gets hit by a vicious second wave of COVID-19 — say that investors should not get nervous, and hold on to and perhaps even add to their equity portfolio?
Financial markets are ruthless in ignoring the present and discounting the future. We have seen this most recently in 2020, when even with cases in the US (and particularly in the New York, home of Wall Street) rising the way they did, the market bottomed out in March and then did stupendously well as the year progressed. Even though people are dealing with the crisis and consequent tensions in their personal lives, the equity markets are looking six and 12 months ahead. They are expecting the crisis to abate soon or end with more and more people getting vaccinated and the government and healthcare sector finally gearing up to give people the care they deserve
Over the past 25 years (March 31, 1996 to March 31, 2021) the Indian market (Nifty returns including dividends) has gone up at the rate of 12.9% per annum while Indian investors’ favourite, gold, has given returns of 9.3%. Equities have also done better than returns from the debt markets over this period, as they should.
As the public battles with the coronavirus, it may be useful to see the kinds of problems the market has negotiated over the past 25 years. Each of these were seriously negative for the markets when they occurred and would have shaken even committed investors, but the markets still delivered a reasonable 12.9%.
On the political front, last 25 years have seen eight coalition governments, three different governments in two years, a government that lasted a mere 16 days and a surprise loss in elections leading to 13% fall in markets in a single day in 2004.
Politics has not been the only bane for the markets. Last quarter of a century has seen the Russian Crisis, Asian Crisis and global financial crisis (in that order) along with bursting of the technology sector bubble in 2000 and the attack on World Trade Centre in 2001. Other major India-specific negatives over this period have been US sanctions on India (in 1998, after India’s nuclear tests), limited war with Pakistan in Kargil in 1999, attack on Indian Parliament (2001), horrifying attack on Mumbai (2008), and various stock market and corporate scandals occurring with sickening frequency.
Despite these significant negatives, the Indian market has delivered strong returns, both absolute and relative, over the years. However, this should not be a surprise for there is strong evidence from the last 100-plus years of data regarding the outperformance of equities across countries and across time.
In their book Triumph of the Optimists: 101 years of Global Investment Returns, the three authors (all professors of the London Business School) noted that “the risk takers who optimistically invested in equities were the group who triumphed over the long term”. Clearly investors do not like volatility and need higher returns than what they can get for holding government bonds (measure of safe returns). Equity risk premium (sometimes referred to as “excess returns”) is the extra return that you get for holding equities over holding long-term bonds of the same country. The authors used 101 years of stock-market-returns data for 16 different countries and showed that, between 1900 and 2000, annual equity risk premium was approximately 5.6% for this group of countries (basically all major countries where 100 years of data was available including the US, UK, Japan, Germany and Switzerland). In plain English, investors in equities earned approximately 5.6% more per annum from owning equities versus owning long-term bonds in these countries over the 101-year period.
Since some readers may object to using such long-term periods to justify buying equities, the authors also broke down the holding period to 10-year periods. They found that, over 10-year holding periods, the investors on average earned approximately 4.7% extra for owning equities over the long bonds of the same country’s government.
On the other hand, if you do not believe 101 years of data for 16 countries is enough, why not extend the horizon a little bit. Jeremy Siegel in his book The Future for Investors collected financial data for over 200 years for the US market (1802 to 2003) and concluded that real stock returns (nominal returns less inflation) on equities ranged between 6.5% and 7.0% over all long-term periods examined. No other asset — not bonds, not treasury bills, not gold — displayed returns anywhere near the returns of equities. Breaking down this long-term period into shorter phases did not matter much. From 1802 to 1870, or the middle period from 1871 to 1926, or the period since 1926, which included the worst stock crash and the Great Depression or the period since the Second World War — all displayed similar real returns for equities of 6.5% to 7%.
Barton Biggs in his book Wealth, War and Wisdom approached the analysis in a different way but came to the same conclusion. Looking at the returns in the 20th Century for countries that he called the “stable lucky ones” that were spared any catastrophe (the US, UK, Australia, Canada and so on), he concluded that inflation-adjusted returns for stocks beat returns for bonds and bills (and all of them did better than inflation). More surprising was the conclusion that, even in the loser countries (Germany, Japan, Italy and so on), stocks beat bonds and bonds beat bills (though only stocks managed to beat inflation in the loser countries). So even in countries where the risk turned out to be the highest, the risky asset class of stocks did better than the “safe” asset class of bonds and bills.
The practical takeaway is that investors should remain committed to the equity class over the long term. You may sell individual stocks or funds or change fund managers if they disappoint you, but do not lose faith in the concept of equities for that is something more basic and has stood the test of time.
I still do not recommend that 100% of your assets be held in equities. Equities are volatile and it is equally important to be able to handle the volatility of the markets in a healthy way. Buying into the concept of equities will help you handle with confidence periods in which the market is not going your way. If you have 10 to 20% of your portfolio in cash/debt, it will give you a sense of control since you will look at market corrections as a welcome opportunity to buy rather than being on the tenterhooks all the time because you are fully invested (or god forbid, leveraged). To take advantage of the long-term returns from equity, you have to be invested in equities for the long term and that requires you to take the risk that you can handle without losing sleep or throwing in the towel at the wrong time.
(The writer is the founder of and fund manager at Helios Capital.)