Long ago, perhaps till about 2000, I used to be a little defensive while advising people that almost all their long-term savings should be in stocks or equity mutual funds. In those days, it was hard to come across anyone who did not react quite negatively to such a view. Equity was for punting, while savings were to be kept in deposits of one kind or another. At that time, perhaps 99% of savers had anti-equity view. Those days are long gone and the proportion of savers who are anti-equity is now down to a mere 95% or so.
Even so, nowadays, I see no point in breaking it gently to anyone, so I'll come straight to the point: Your long-term investments must be kept in equity-backed investments. There are no ifs or buts here. If you do not do so, you will expose yourself to the frightening spectre of old-age poverty. Except for the small proportion of people who have inherently inflation-linked lifelong income (like a lot of rent, or perhaps a government pension), every other saver must invest almost all their long-term investments in equity. In last week's edition of this column, I had shown that deposit-type savings--whether FDs, PPF or anything else--yield almost no real (above inflation rate) rates of return. The result is that those who depend on these for their old age income need much more savings in order to avoid hardship. Therefore, unless you have rental income that can be hiked periodically, or you have a government pension, you will have to fight inflation yourself.
And in this battle, the only effective weapons you have are equity backed investments. However, the problem with that is that most of us still live in the India of the past, one that was a pure fixed-income country. Except for a small handful of punters, investments of almost everyone were made into deposits. This was true at least till the mid-nineties. The only time the investor dabbled into equities was when he filled out his application form for an IPO, or just 'issue', as it was then called. The 'issue' worked more like a lottery ticket than an investment. Then, from about the mid-nineties onwards, there arose a small but distinct equity culture where individuals started investing in equity mutual funds in reasonable numbers. However, when seen in the context of the size of the saving population and the kind of money that is invested in deposit-type products, equity exposure is still tiny.
To understand why inflation can be defeated only by equity-based investments, let's step back and think from the basics. There are only two ways of investing money--either you can lend it to someone, or you can own your own business. When you lend, you get a basic return but do not share in the upside. For anyone who is good at doing business, the best way to invest is in your own. Fortunately, because of the existence of stock markets, any of us can become owners (or rather, part-owners) in a business. We can reap the financial advantages of being owners with very few challenges that the real owners face.
This means investing in equity. Equity could mean buying shares but for beginners it generally means investing in equity-based mutual funds. To appreciate this, one should understand the source of equity profits. The ultimate source of profits in equity is the general growth of the economy. The fear that people have is that of volatility. The daily noise from the stock markets is such that the overwhelming impression we get is of volatility. However, this is an illusion. If you were to look at the equity markets once every five years, you would get the following (annualised) returns: 6.5, -1.3, 81.4, -0.7 and 12.2. That makes it pretty clear what the right choice is, doesn't it?