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What are Stock Markets?

Equity returns can be excessively volatile with gains and losses over a wide range; but returns tend to beat inflation, over the long-term

Stock markets make many people nervous. Conservative people swear markets are no better than gambling casinos. Others swear by markets as offering one of the best possible investments.

What is the reality? As always, the truth lies somewhere in-between. Markets are risky-there is no denying that. However, markets also offer better returns than most other conventional financial instruments.

The case for investing in equity can be made very simply. Over the long term equity tends to offer returns that cannot be matched by any other normal investment.

Take a look at the stock market performance of the last 20 years. In January 1994, the Nifty was trading at 1081 points. It closed on June 20, 2014 at 7511. That is a compounded 20-year return of 10 per cent, ignoring dividend yields, which averaged another 1.5 per cent.

It is possible that shrewd well-timed investments in real estate or in gold might have yielded more. But this is a solid double-digit return which was available for simply staying passively invested. In practice, any systematic investor would have made a great deal more than this.

Alert readers (or long-term investors) will note that the returns from the stock market rose in the past 10 years. There was a breakout in 2004 and the stock market went into a new phase of behaviour.

As marked on the 20-year chart, the first 10 years, 1994-2004 saw compounded annual returns of just 5.2 per cent. The next 10 years, from 2004-2014 saw CAGR accelerate to an amazing 14.9 per cent. In April 2004, the Nifty traded at about 1800. By June 2014, it had reached 7515.

This acceleration in stock market returns has occurred despite the deep bear market caused by the global financial crisis. In fact, returns have been highly positive despite an economic slowdown.

As everybody is aware, inflation also spiked up through much of this period. We don't have good consumer price index data across this period. However, we do have Wholesale Price Index data. The WPI was at 97.5 in April 2004 (the WPI series was launched in 2004-05) and it hit 182 in May 2014. That translates into a pattern where wholesale inflation ran at 6.33 per cent through this 10-year period. Any investment had to beat this number to register a real return. The Nifty beat WPI inflation hollow across the last decade.

The data has been normalised to compare inflation and the Nifty over 2004-2014. One way to interpret this: the buying power of ₹100 in April 2004 was equivalent to the buying power of ₹187 in May 2014 when the last WPI data was available. However an investment of ₹100 in the Nifty in April 2004 had earned ₹397 by May 2014.

Unfortunately, the case against buying equity can be made equally simply.

The CAGR of the Nifty over April 1994- March 2004 was 5.2 per cent. Through that period, WPI ran at 5.22 per cent with a WPI index value of 107.5 in April 1994 versus a WPI value of 179 in March 2004. Net-net, equity would have scored a small positive return if we take dividend yields into account. However, consumer inflation may have been running higher and the real return could have been negative over a 10-year period.

When we look more closely at the data for 1994-2004 period, another characteristic comes to light and that is probably the one that scares away conservative investors.

Equity returns are really volatile. Over the period 1994-2004, the year-on-year returns varied from between plus 89 per cent in 2003-04 and minus 25 per cent in 2000-01. In fact, only four of those ten annual returns were positive. Many investors lack the risk-appetite to absorb this sort of pattern of alternating large gains and large losses. Volatility of return did not ease off between 2004-2014, although that period saw much more in the way of positive returns. Eight of the last ten YoY returns were positive. But the magnitude of return varied from minus 41 per cent to plus 78 per cent. Equity is volatile in an intrinsic way. There is no way to completely eliminate that volatility from the performance of any given portfolio. However, a longer holding period tends to cut down the risk. Predicting the performance of a given stock or of a stock market is more or less impossible if one is speaking in terms of price movements in the next day, or the next week. It is possible to make money trading very short-term but only by extremely good money management rather than consistently correct prediction. However predicting the performance of a stock over the long-term is relatively easier. If a stock or a stock market see consistent growth in earnings, the chances are quite high that the share price will also gain consistently over the long term.

One way to see how volatility of return smooths out is to check for rolling returns across different time periods. Above, we were looking at YoY returns in a fiscal-that is from 1 April of a given year to 31 March of the next calendar year. This is a point-to-point return between two fixed dates. Since the stock market's movements are not linear, another pair of fixed dates will yield different returns.

Try a thought experiment. An investor might buy on any given day and hold the position for a year. Or he may choose to hold for two years, or three years or five years. These rolling returns can be averaged to give a sense of the level of risk for a given time period.

If returns are rolled across 1-year periods for the time period April 2004 to June 2014, there are a total of 2,296 rolling 1-year periods. The averaged return is 18.6 per cent. The return is positive across 1,808 periods and negative for 488 periods. This means that there are 3.7 positive one-year returns across this period for every single negative return.

If a similar rolling return is calculated over 2-yr, 3-yr and 5-yr periods, a pattern emerges. When we annualise the rolling returns, it seems the longer time periods give lower returns on average. But the number of periods of negative return also falls sharply as the period lengthens. An investor who holds for 5-year periods is 31.6 times as likely to get a positive return as a negative. The returns tend to be much smoother with fewer negative swings for longer time-periods as shown in the graph of 1-year rolling returns versus 5-year rolling returns.

The optimum holding period in terms of high average return and high pos:neg ratios would also involve tax-related calculations and assessment of personal risk-appetite. But it is clear that a long-term investor is likely to receive relatively more stable returns with much fewer chances of loss.

Summing up
Equity is a volatile instrument. Returns can be excessively volatile with gains and losses over a wide range. But returns will tend to beat inflation, and other conventional investments, over the long term. This has been the pattern of the past 20 years and more in India. It has been the pattern of the past 100 years and more in developed markets. An investor who is willing to stay in the market for longer periods will receive a more stable and smoother return.

The writer is an independent financial analyst.