How often have you heard statements that go something like 'Stocks have returned a fabulous x% per annum over the last x years'. 'Stocks' in the above sentence is at various times readily replaced by any other asset class like gold, real estate, silver etc. Specific companies too find themselves a part of such descriptions about the returns their stocks have given over the last 1, 3 or 5 years.
Yes, this is one very ubiquitous exercise that is used across financial markets to calculate the 'returns of an asset class', or the 'returns of a stock'. More so, what is tacitly implied is that these returns are cast in stone and one can reasonably expect it to produce similar returns in the future too.
Lest we fall prey to Bertrand Russell's wise quote "Most people would rather die than think: many do", let's give the above popular methodology of calculating the general 'returns' inherent in an asset class some thought.
The calculation of your return on an investment, especially when it comes to various asset classes, is a tricky affair. More specifically, returns are calculated by dividing the current price (numerator) by the price when we made the investment (denominator).
Thus, what happens is that in many situations, the factors affecting the price of that investment at those two different points in time have an overriding impact on the performance of the investment. To the extent that the particular asset class by itself (the actual change in its intrinsic worth) is sometimes rendered almost irrelevant.
An example should make things more clearer -
| |
Absolute Return |
Compounded Annual Return |
| Over last 1 year |
218% |
218% |
| Over last 2 years |
54% |
24% |
| Over last 3 years |
8% |
3% |
| Over last 4 years |
30% |
7% |
| Over last 5 years |
99% |
15% |
| Over last 6 years |
176% |
18% |
| Over last 7 years |
183% |
16% |
| Over last 8 years |
146% |
12% |
| Over last 9 years |
62% |
6% |
| Over last 10 years |
-46% |
-6% |
| Over last 11 years |
513% |
18% |
| Over last 12 years |
3596% |
35% |
Data Source: Prowess
The above is a tabulation of the returns that you would be fetching today if you would have bought the stock of India's third largest IT company Wipro at different points of time in the past.
So if you were told that the stock of Wipro would have fetched you a return of 99% over the last 5 years, of what relevance would that piece of information be to you? Does it symbolise the returns one can expect from Wipro over the next 5 years? Does it reflect the inherent strength of the company Wipro? Does it reflect how business has been for Wipro over the last 5 years? Does it reflect the quality of Wipro as an investment?
The answer to all of the above questions would be an emphatic NO. The more alert amongst you might have noticed from the table that depending on whether one is calculating returns for the last 1, 5 or ever 10 years, the 'returns' that Wipro will have given you as an investor will vary greatly.
A similar parallel can be drawn for the calculation of the returns of any asset class. The ultimate point being that there are no returns that are 'inherent' in any asset class (implying returns which can be automatically expected to be achieved in future too). They are more a factor of the valuations that are prevalent at the time of investment and the long term fundamentals of the asset class under consideration. Hence, the next time someone tells you that equities have returned so-and-so percent returns over the last 5 years, you know what to make out of it.
VLR
Mar 2, 2010Spot on Manu