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Do equities make sense? - Views on News from Equitymaster
 
 
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  • Mar 23, 2004

    Do equities make sense?

    In one of our previous article, we had analysed the response of our viewers to the question "Do you invest in equities due to lack of other investment options? A majority of our viewers had indicated that their investment decision was driven by lack of other investment avenues. Though the premise (lack of other options) of investing in equities may be skewed from our perspective, in this article, we would like to highlight the fact that among various asset classes equities perform the best over a long-term horizon.

    Maturity Value in Jan 04
    Instrument Allocation Amt
    Invested
    If invested
    in Jan 99
    If invested
    in Jan 00
    If invested
    in Jan 03
    Debt Instrument 30.0% 30.0 47.3 43.2 32.3
          57.5% 44.0% 7.5%
    NSE-Nifty 40.0% 40.0 74.9 46.8 69.5
          87.4% 17.1% 73.7%
    Property 25.0% 25.0 30.0 28.6 26.7
          20.0% 14.3% 6.7%
    Gold 5.0% 5.0 7.2 7.3 5.8
          44.1% 45.5% 16.0%
        100.0 159.4 125.9 134.2
               
      CAGR   9.77% 5.92% 34.20%
      Time frame of invest.   5 years 4 years 1 year

    In the table above, we have highlighted an asset allocation scheme, which includes assets like debt, equities, property as well as gold. The table, apart from the percentage allocation in various assets, also indicates the returns over a period of one, four and five years. The table also shows the percentage return of each asset class over the three year time period. One of the most evident conclusion from this exercise is that each asset class, except for gold, has yielded maximum returns over a five-year period.

    Another observation we can make from the table is that, equity investments have yielded the best returns over a five-year period. This is despite the tech bust witnessed in early 2000. While these two observations are important from an asset allocation perspective, we conducted another exercise to find out whether there are any significant changes in the returns, if equities are completely removed from the asset allocation scheme. The table below indicates the result of the exercise.

    Maturity Value in Jan 04
    Instrument Allocation Amt
    Invested
    If invested
    in Jan 99
    If invested
    in Jan 00
    If invested
    in Jan 03
    Debt Instrument 43.3% 43.3 68.3 62.4 46.6
          57.5% 44.0% 7.5%
    Property 38.3% 38.3 46.0 43.8 40.9
          20.0% 14.3% 6.7%
    Gold 18.3% 18.3 26.4 26.7 21.3
          44.1% 45.5% 16.0%
        100.0 140.70 132.92 108.75
               
      CAGR   7.07% 7.37% 8.75%
      Time frame of invest.   5 years 4 years 1 year

    We have distributed the sum invested in equities into other asset classes equally. So, investment in debt increases from 30.0% to 43.3%. What we observe is the fact that over a five-year period, the return of the portfolio of assets actually reduces in comparison to the earlier asset allocation scheme (which had an equity exposure). This highlights the fact that in any asset allocation scheme the investor loses out on a significant amount of returns if he does not have an exposure to equities. Except for the four-year time horizon, the return of the portfolio with equities has outperformed the portfolio without equities. This could be attributed to the fact that 2000 was a peak year for the stock markets. Though this is not an excuse, a prudent investor would have changed his asset allocation mix (i.e. reduced exposure to equities) during boom times in equities.

    In conclusion we would want investors to dwell upon certain key facts.

    • First, over the long term (the five year portfolio), the volatility in the performance of stocks evens out and could benefit investors (this despite the three year bear market).

    • Second, while equities may be a risky proposition, the non-inclusion of the same in any asset allocation scheme may result in subdued gains. The case of subdued gains is relevant at this juncture due to the fact that yields on most of the fixed return products (like fixed deposits, company deposits, NSC and PPF) could be inadequate to meet future financial needs. The times of 14%-15% returns on fixed return instruments are history. Investors need to assume higher risk in order to ensure that their returns are not eaten up by inflation. Equities should be a must in any asset allocation scheme.

    • And more importantly, do not change the asset allocation mix. Irrespective of a bull market or a bear market, your risk profile remains the same. May be, it will reduce as your age increases. What we are saying is that do not go overboard on equities also. One wrong decision could wipe out gains.

    At the end of the day, it is a matter of discipline. We would like to re-iterate that an asset allocation criterion varies from investor to investor. While we have presented a case for equities, one has to keep in mind that a disciplined asset allocation approach is extremely critical. Happy investing!

     

     

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