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Understanding the basics of equity returns

The wildly different equity return in different countries has a simple basis to it

Last week, a reader sent an email with what one should call a beginners' question. He wants to know why US equity markets have returns of around 12 per cent a year while Indian markets do about 25 per cent a year. I'm not sure of the exact period over which these numbers were based because the returns could be higher or lower. However, the general point which puzzles my correspondent is true.

When I called this a beginner's question, I meant it in an entirely positive way. I get a lot of questions, both from experienced investors and beginners. Often, the ones from experienced investors refer only to some narrow issue that is bothering that investor, while beginners' questions are of universal utility. Beginners often tend to question the basics, to question the things that everyone thinks are settled truths. These are the questions whose answers 'everyone knows', except that they actually may not. Which is why even after two decades of thinking and writing about investing, I find that the real opportunities to learn comes when one answers the questions of a beginner and learns from them.

The question brought to my mind something that Warren Buffet said recently in an interview with Outlook Business magazine. On how stocks should be priced in the future, Buffet says that, "If you tell me what the interest rate will be, I will tell you what stocks will be at". At first reading, that sounds like a recipe from someone who's saying that here's how to predict how stocks will be valued in the future. Here is the interest rate, and here's the future of stocks. Actually, The Oracle of Omaha is probably saying the opposite. He is saying that since interest rates cannot be predicted, neither can stocks be.

He says that the ultra-low interest rates could not have been foreseen and these low rates makes stocks more valuable because of the opportunity cost of buying government bonds at one per cent return versus buying stocks. When the world returns to higher interest rates, then stocks will suddenly start looking a lot more expensive. It's emphatically not a prediction. Instead, it's what's called an IFTTT answer nowadays--If This Then That.
As for the beginner's question, the answer to that too is related to interest rates, or at least the floor level of the equity returns is. There's a basic level of risk-free returns that are available in an economy. Generally, that's the rate at which the government borrows money because the assumption is that the government will always pay back your money. Riding on this concept of risk free return is that of the risk premium. Risk premium refers to the amount by which returns from riskier investments must exceed the risk-free returns for it to be worthwhile for investors.

In India, we can currently get what are practically risk-free returns of 8.5 to 9 per cent by making a fixed deposit in a bank. How much higher than that would you want to get for putting up with the risk and volatility of equity? It's unlikely to be one or two per cent or even five per cent. Similarly, in the US, it isn't possible to get a risk-free return of more than around one per cent. Would equity investors in the US be willing to hold out for as much as Indian equities earn? Clearly not, since their safe alternatives earn them much less.

The second, implicit part of the beginner's question is that all this is basically driven by inflation, which is effectively the decline in the value of your money in the economy. In real terms, the inflation rate is the floor, which effectively means zero returns. A little above that is the risk-free rate of return, and arrayed above that are a variety of other investments at different risk-return trade offs. Of course, this is not the whole story. It just tells you the average return, within which there's a huge range of actual stock returns, but that's a whole different story.