In our last post, we understood that investing in equities is a reasonable proxy to entrepreneurship as you get to have part ownership in a business. So intuitively entrepreneurs on an average should have made reasonably good returns over the long run, and as a corollary, equity investors should have also made good returns in the long run.
Let’s see some historical data on how equities have performed.
I have refrained from referring to a point to point return starting from 1979 till 31-Mar-2016 and instead taken a more practical approach and have analysed all time periods of 1Y, 3Y, 5Y, 7Y, 10Y and 15Y covering each and every day since 1979.
As seen from the table, the one year return for Sensex has ranged from a high of 265% (in 1991-92 period when Indian economy was liberalized) to -56% (during the 2008 US Sub prime crisis). The range of return outcomes is extremely wide for a 1Y time frame. Similarly the probability or the odds of a negative return is also 30% i.e 3 out 10 times historically, an investor would have made negative returns if he had invested in Sensex with a 1Y time frame.
Thus our first conclusion is that,
It is extremely risky to invest in equities for a short time frame given the possibility of a negative return and an extremely wide outcome range.
As seen from the table, the odds of negative returns improve from 30% on a 1Y time frame to 9% on a 5 year time frame and to almost nil on a 10Y time frame.
Our second conclusion is that,
The odds of a negative return gradually reduces as we extend the time period of investing
Over time periods of 5 years and above equity returns have averaged around 15-16% historically. While this average no of around 15% is what is commonly quoted everywhere as the long term returns, we also need to be aware of the chances of getting those returns as equity outcomes are always in a wide range. The probability of making the expected returns of >15% also improves with higher time period for investing i.e 50% odds in 5 year time frames which improves to 62% in 10Y time frame.
In equity investing, as the outcomes (returns) are not certain our key objective is to improve the odds of a higher return and at the same time reduce the odds of a negative return
From a quick glance at the above data, we know that increasing the investment time horizon is the simplest way towards this endeavor.
Once we get a sufficient time frame in place, the odds of higher returns can be further improved by evaluating the two primary drivers of equity returns (earnings growth and valuations). I will be covering this in a separate post in the coming weeks.
Thus to start of as an equity investor, the bare minimum time frame we will be needing is at least 5 years. Of course, the longer the time frame the better. You may argue that even with a 5 year time frame the odds of 15% return is only 50% and odds of negative returns are ~10% (add to it 30% odds of less than 8% return – remember the purchasing power !!). But all is not lost, as we will be improving these odds by using asset allocation (evaluating valuations and earnings growth + combining other asset classes) and mutual funds (active stock selection as against the passive index).
And, most importantly, if you need money in less than 5 years, then its better to avoid equities.
P.S – Geek alert !!
The tabulation also has standard deviation provided along with averages. Generally its a good practice to evaluate averages along with standard deviation which gives an indication of “how spread out the outcomes are”. A smaller standard deviation indicates a tighter outcome band (think of fixed income or F.D returns) and higher standard deviation indicates a wider outcome band (think of gold, equity returns etc).
The way to interpret a standard deviation is :
68% of the times the values have been between average+ standard dev and average-standard deviation
Eg: From the table we can see that, equity returns on a 5Y basis have been between 3% and 29% for around 68% of the times
If you find this a little complicated, no worries and kindly ignore this and it wouldn’t make too big a difference to your investing !!