The greatest problem that your investments have to solve over the long term is inflation. You have the lethal combination of inflation and interest rates. This means that inflation-adjusted interest rates that we earn from fixed-income investments like deposits, etc., are actually negative when compared to the real inflation rate that consumers face.
What is worse is that at this juncture, the economic management of our country is such that neither of these problems is going to get solved in a hurry. It could well be years before fixed-income returns rise above the inflation rate in any meaningful way. For investors who need to preserve and grow their money, this presents a great dilemma.
Equity is one asset that has the potential to beat inflation to earn real returns. It is for this reason that your portfolio should have a significant exposure to investments in equity.
However, there's a problem with that. For the normal Indian investor, investments in equity is psychologically the equivalent of risk. The risk of losing their money when investing in equity keeps most Indians away from investing in these instruments, even among those who realise the inherent need for inflation beating returns. We have been brought up to mentally equate investing in equity with the volatility of the stock markets. Even people who are peripherally aware of investing are aware that stock markets keep rising and falling sharply. One moment, investors are deliriously happy, and the money is rolling in, and in the next they are ruined and devastated.
However, this volatility is just an illusion. In reality, the returns from equity are not only high but they are quite safe too. How can this be? How can returns from a type of investment that is volatile be high and safe? The answer is to understand that the same thing can look very different at different scales.
Here's a question that will demonstrate the point: How long is the coastline of India? The official answer is 7,517 km. Do you think a person walking exactly along the coast line from Gujarat to West Bengal would come up with this answer? What about an ant? If an ant walked the entire distance, would it come up with the same answer? How about an aeroplane? If you flew an aeroplane along the coastline, would you arrive upon the same answer? No.
In each of these cases the answer would be very different. The ant may come up with an answer thousand of km higher because it would follow each nook and corner of the coast at the scale of millimeters. A human being would follow it on a scale of feet and come up with a lower answer. An aeroplane would follow it only on the scale of many kilometres and would come up with a far lower answer.
Stock market volatility is a bit like this. If you track the markets everyday, you will see many ups and downs. If you track it once a month, there will be fewer ups and downs. On the scale of a year, the ups and downs would be even fewer and if you were to pay attention to the markets only once every two or three years, there would hardly be any volatility. Now imagine the scenario once in a decade or for even longer periods.
See the two charts below. One is that of the Sensex' daily movements from 1994 to 2019. The other is the same time period, but marked only once in five years!
The first graph can worry the bravest of investors. However, in the second graph, there's practically no volatility.
If you had invested in equity in 1994 and then bothered to check your investments only once in five years, then sometimes your investments would rise more and sometimes they would rise less but there would be nothing that would justifiably count as volatility. Over a longer time such as a decade or more, the movement of the Sensex evens out, thereby reducing volatility in reality.
The moral of the story is quite clear: the idea that investing in stocks can lead to frequent losses holds true only if you are a short-term trader. Over sufficiently long periods of time, you are like the aeroplane flying over the coastline. The little twists and turns that vex the ant are not your concern.
But how are you to invest in equity? To invest in equity sensibly and make money out of it, there's no need to actually get into stocks and shares yourself - equity mutual funds will do the job for you.