(2) Do equities (stocks) guarantee good returns even in the longer run?: Finance Trading Times

(2) Do equities (stocks) guarantee good returns even in the longer run?


Very often I hear this reason from people who trade in stock market – “I am a long term investor, as equities always give a better return in long term” OR “I do NOT trade in short term, I invest for long term – equities give better returns in long term”.

Most of the times, this kind of justification come from people who have bought a particular stock, and now the value of that stock has come down. Hence, they are sitting on unrealized loss on their trade. It’s human nature to justify their own deeds – either by an explanation or by a counter action. I usually hear the explanation as mentioned above, and I’m convinced that the person quoting the reason has made a loss on his trade.

An honest confession I want to make here is that some 2-3 years back, I was also one of these losers quoting similar reasons J

My colleague, whom I’ve talked about in my past article , also quoted the same reason for the loss-making stocks in his portfolio.


Having worked in the pension fund industry for some time after my finance studies, I could get the understanding of the dangers of this kind of long term strategy. Try this: Search on Google the following term (without quotes) - “UK pension fund problems” and you will see a list of articles coming up on the results page. One of these articles is published by BBC and comes as the first result (http://news.bbc.co.uk/2/hi/business/2082800.stm)

Read this article carefully, and you’ll find the main reason being quoted is as follows: “But the problem has been exacerbated in recent years by dwindling stock market returns.

This is the reason which is quite commonly quoted by the pensioners as well as the common man for the pension fund problems of UK. However, the reasons for pension fund crisis go beyond that. Let me demonstrate this with some historical real-time data instead of a hypothetical example. During this case-study, I’ll also refute two most commonly believed myths about the stock market.

Below is the graph that shows year-on-year average return on S&P 500 index (green bar graphs) and the red line indicates the risk-free 1 year bond return. (S&P index is US stock market equivalent for the Indian Sensex or Nifty). The graph is from 1975 to 2004:



Suppose that you believe in the commonly accepted principle: “Equities (Stocks) give better returns in long term” and you start investing in the equities market in the year 1975, thinking that in the long term you will make decent returns. This was what majority of the individuals did when they were working in 1975 and planning for their retirement, which was suppose to happen sometimes in 2003-04. Over the period 1975-2004, they regularly invested in equities following the same principle. However, at retirement, they found that most of their savings have gone down.

How??

Look closely at the green bar graphs for the period 2000 to 2004. The stock market has gone down consistently. This resulted in a total accumulated 60% loss on the stock holdings that people have been accumulating since 1975. Since they had to retire by 2004, they were relying on their “intelligent investment” in stocks. At retirement, they were not having any further scope to work and get salary – so they were forced to sell their holdings. All this resulted in a big mess for them, as their holdings had to be sold at the much lower market prices, due to the downfall of the stock market consistently for 4 years from 2000-2004.

This historical case demonstrated the dangers of investing in equities based upon the “long term better equity returns” concept. Remember, everything has a deadline – no investments can last or is secure forever. When you will need the money, you never know. Imagine how will you feel if have been saving your hard earned income continuously for last 30 years, and at the end when you’re about to retire you discover that the value of your savings has gone down drastically in the last 3 years of your investment period, and you’re left with only 40% of your money –rest 60% going in a loss?? This was the case with retirement planning investment, but the same can be extended to other similar situations as well –for e.g. Let’s say you just had a new born kid, and you started investing for 18-20 years period, so as to secure money for his costly college education (MBA/Doctor/Engineer), once your kid grows up. It is possible that you find that by the time you needed money, your stock holdings have come down in market value drastically.

This case refutes our first myth – the myth that equities (stocks) give better returns in long term.

Now let’s look at the red line which indicates the RISK FREE Bond returns (interest rates) for the same period 2000-2004. What do we see?

The returns from bonds have gone done consistently over this period. Also, we’ve already discussed that the returns from stocks have also gone down consistently. This refutes our second myth – the myth that bond returns (interest) and the stock market returns go in opposite directions – when one falls, the other rises and vice-versa. As it can be seen from the above graph, they both have gone down together, consistently for last 4 years.

In the beginning of this article, I’ve mentioned that the problems with Pensions funds were not just by the losses from the stock market. The additional reason being there were low returns from the bond market as well.

So, let’s not live under some false assumptions and commonly accepted principles. The case that I’ve presented in this article in NOT a hypothetical case, but it is what has happened in the past. Let us not believe that “This Cannot Happen” or “X is better in Short term and Y is better in the Long term”. Things happen randomly. Forget about the common man, even the highly sophisticated and educated financial investment managers and experts with decades of experience in the finance industry could not predict what we’ve seen in the period 2000-2004.

It’s risky - Play Safe, don’t get carried away by emotions.
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18 Comments: Post your Comments

nickp2 said...(on 29 May 2007 at 11:50 )  

Hi Shobit,
Can you compare the same investement in any of the bluechip company over the 2002-2007 period and show us how investing in a Bond would be better than investing in a bluechip company, say (Reliance,Infosys,ONGC etc)?
Thanks

Investment n Trading Advisor said...(on 30 May 2007 at 01:39 )  

Nick,
The question here is not just about Bonds. I am more concerned about the risk that ppl take in buying stocks.
You are right that in the 2002-2007 period, the bluechip companies made enormous profits. Obviously, the market indicators (Sensex/Nifty) are having bluechip companies as its constituents, so once they go up, the market automatically goes up.
Here is the % profit for companies in 2002-2007 period:
Infy - 500%
Reliance - 340%
SBI - 450%

That was the reason that market went up by almost 350%, because these companies performed better than the market. But just think on the other side also. At the same time,there were some other companies which did NOT perform better than the market....So that's why the average market rise was 350%, as compared the market outperformers like Infy, which had 500%.
Simple maths show that the for the average value, if some values are above average, there have to be some below average, so that the average value can be calculated.

The 2 BIG questions are:
1)Whether you are able to predict the period when the market will keep going up and for how long???
2) Can you specifically select the so-called blue-chip stocks, that will DEFINITELY do better than the market?? What if you had selected the blue-chip stocks which were much below the market indicators?

THis is called SURVIVORSHIP BIAS. We only look at the survivors that have managed to get better returns - how about those that were left behind? When the market goes up, everyone (and their aunts) make money...important fact is that when the market goes down, majority of these ppl will loose their shirts (and their pants too).

In my next article, I'm going to differentiate between the Good and the Bad companies....
Just wait for that to be published

Anonymous said...(on 30 May 2007 at 04:18 )  

Dear SHOBHIT,

Please let me have the benefit of your knowledge ,experience and advise!!!

My email is amit_at_indigo@yahoo.com

Best wishes,
Amit

Anonymous said...(on 30 May 2007 at 05:03 )  

Hi Shobit,

Good job and really interesting story. I have been an investor since 2000 and based on your calculation I did my part of trades. I got a descent 16% y-o-y apart from the 20% I had invested in PPF, RBI, IDBI, ICICI bonds. I my view, one should always sell his stake when he reaches a certain level of profit irrespective of the duration. E.g. I follow the WB way and sell at 15-20% returns and hold some of the Blue chips in a sector...again following WB :)

Thanks a lot for instilling confidence in my strategy, with your blog and keep-up the good work.

Best regards
Amit Singh
vertu74@gmail.com

shashi said...(on 30 May 2007 at 18:25 )  

Hi Sobhit ,
I too am looking forward to the point raised by nickp2.
Thanx

Investment n Trading Advisor said...(on 30 May 2007 at 22:48 )  

Shashi,
I've already responded to Nick's comments.

Mahen said...(on 5 June 2007 at 04:07 )  

hi,
In a general sense what you are saying here is true. But what if we stick to the specific case of India. The indian companies have shown phenomenal growth in last 4 years. And as most of the analysts believe that the so called "Indian story" is still in progress, dont you think investing in Indian equities with 5-10 years horizon will be a good thing. Basically, what if we compare the sensex data for 20 years instead of S&P 500

neeraj said...(on 5 June 2007 at 23:45 )  

hi

Thanks for yhis information

My mail ID is

neerajkrec_1980@yahoo.co.in

Please send me more information

Neeraj

Calisto Francis said...(on 24 June 2007 at 07:28 )  

hi Shobhit

thanks

would request you to send me your articles to my email id
francis69@gmail.com

thanks

Calisto Francis said...(on 24 June 2007 at 07:28 )  

hi Shobhit

thanks

would request you to send me your articles to my email id
francis69@gmail.com

thanks

Anonymous said...(on 26 June 2007 at 06:14 )  

Hi shobit,

Send me ur vital information and expert comments to my mail id
premraj.joshi@gmail.com

Anonymous said...(on 28 June 2007 at 02:52 )  

Hi. I would like to receive your articles on ak.3a@zapak.com

Thanks

Karun Bir Singh Sandha said...(on 5 July 2007 at 00:43 )  

Hi Shobhit,

Again very good example, similar case happened with me. Last year I called up people from various insurance companies because I wanted to invest my money somewhere for tax benefits.
HDFC Std Life guy came with laptop showed me fig if market gives returns of 10% your money would swell by these many times. Policy duration was fixed I think at 20 or 25 years. I asked him what will happed if after 20 years when I need money market suddenly falls? Can I extend my policy ? Answer was 'No'. Then I thought how dangerous it would be if my investment gets 20 times and just before I want to take out money market falls .... Solution provided by the agent was 'transfer your money slowly on debt side' ......

Karun

Karun Bir Singh Sandha said...(on 5 July 2007 at 02:06 )  

Hi

Sorry forgot to mention that was ULIP plan of HDFC Std Life.

Karun Sandha

Anonymous said...(on 11 August 2007 at 21:36 )  

1. Why are you comparing bonds and stocks only for the period of 2000 to 2004? Your example says that they have invested from 1975. So why don't you compare what has happened from 1975 to 2000?

2. It may be true that there may be 60% losses from 2000 to 2004 when one wanted to retire. Well, thats why many people advise not to invest all your money in stocks during the last few years when you can not afford to take risk.

The bottom line, equities give better return in long term. But that doesnt mean you should stop researching on them. Observe the market every day but trade once in a while.

Anonymous said...(on 13 August 2007 at 23:05 )  

Hi Shobhit,

Thanks for your effort in bringing this blog so nicely. Lets assume that I have invested Rs.1,00,000 in shares in 1975 and expecting a minumum return of 20% average per year. If you take the power of compounding into account, the amount goes to Rs. 15,00,000 ( the figure may not be correct). After 2000 year, if encouter 60% loss of the gained amount. Still I am on profit right. I am not loosing my principal..only loosing the interest gained during the period. Please share your thoughts on this...




Regards
Diwakar Mahanthi

Investment n Trading Advisor said...(on 13 August 2007 at 23:37 )  

Diwakar,

It's true that you may not loose your principle.
But the biggest problem is with your assumption - 20% compounded each year may not be possible. Sometimes it is 40%, sometimes it is -20%. This fluctuation affects the compunded value in a drastic way. That is what results in a big loss.

Laxnir said...(on 5 February 2008 at 04:31 )  

Dear SHOBHIT,

Please let me have the benefit of your knowledge ,experience and advise!!!

My email is laxnir@gmail.com

Best wishes

Wish you all happy and fruitful trading and investing activities with safety! = = = Post a Comment

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