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Equities: Should be or must be?

Mar 18, 2004

Inspite of the <BSE-Sensex gaining more than 100% in last one year, the benchmark index is trading at a P/E multiple of 15.2x trailing 12 months earnings. However, the markets seem to have gone into a correction mode recently, which has induced some nervousness among retail investors. In this scenario, we conducted two polls on Equitymaster to understand the retail investor's standing. In the first poll, when we asked where would investors like to invest, almost 77% of the people favored equities. So in order to understand the reasons for the inclination towards equities, we conducted another poll asking the investors the following question. "Do you invest in equities due to lack of other investment options? The result was as follows

As it was expected, the larger chunk of the people stated that they are investing in equities due to lack of other investment opportunities (73%). However, 24% of the people would invest in equities, irrespective of other investment options. 3% of the people were not sure about their rationale to invest in stocks.

Before going any further, consider other investment avenues for a retail investor like debt markets (fixed income securities), gold and real estate. Lets take a minute to understand each one of them.

Bond funds are relatively defensive in nature. The yield on bond funds is subject to change in interest rates. Interest rates and Fixed Income Securities (FIS) prices have an inverse relationship. So, when interest rates go up, prices of FIS tend to fall because newly issued securities at higher rates will be in demand. But in the last three to four years (barring most of FY04), bond market saw a sharp rise on the back of significant decline in interest rates. This led to huge gains from bond mutual funds, which we believe is unlikely to continue. We expect bond funds to yield a return of 6% over the next three years. However, there are others like PPF and NSC that have been traditional investment avenues for the purpose of 'guaranteed' returns. At this point, the NSC and PPF (though with a varied investment horizon) would yield an investor 8% return.

Where gold has not been much popular in India for investment reasons, we believe that one should invest some part of his portfolio in gold primarily because gold acts as a hedge against inflation, a situation where the value of currency is eroding. This 'characteristic' of gold exists because the price of gold is impacted by factors that are usually distinct from factors affecting other more popular instruments like bonds and stocks. We cannot compare the returns of gold directly with equity markets because it is a different asset class altogether.

Real estate is also another class of investment that not only provides diversification to ones portfolio but also provides a sense of security. However, it has to be remembered that real estate prices are cyclical in nature and investment requirements are on the higher side. Whether equities are attractive or not, real estate should form a part of one's portfolio.

*Expected return over the next three years for a pure equity fund
**Expected return over the next three years for a balanced fund

While for those who want to go for equities by choice, it is very important to understand that equities are high-risk investments by nature and the kind of returns that we have witnessed in 2003-04 is not sustainable going forward. So, there is a need to tone down expectations. But as can be observed from the graph above, equities tend to be rewarding for long-term investors. While factors like the quality of the stock and the price at which it was bought are important, considering the relative return on other instruments, we believe that equities have a compelling reason to be a part of a investors portfolio. If you are not well equipped to invest directly in the stock market, mutual funds (MFs) are a better option.

However, before taking any investment decision, we suggest investors to identify his/her risk-return profile, the investment time horizon and the future financial needs. While we have presented a case for equities, we also understand that asset allocation varies upon investor to investor. Happy investing!

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