Demystifying equities-Understanding the potential risks and returns


Dear HENRYs & other NRIs, a rational analysis shows that you have no real alternatives but to learn to live with equities throughout your pre-retired and retired lives. Of course, the alternative of significantly compromising on the lifestyle and running the risk of running out of money at around 80-85 years and then depending on the children is a possibility.

We have shown in the
first article that a large corpus (around INR 6 crores) is required to retire with an affluent lifestyle in India. In the
next article we concluded that you had to invest in equities to build the corpus and remain invested in equities for the corpus to last you for the full lifetime. For details about numbers etc. you can refer to those articles.

While you must learn to live with equities, you probably don’t have the stomach for it. Or formally speaking, you have low risk tolerance. Approaching a scrupulous financial planner & advisor with this low-risk status and age of around 50 or more will result in the advice that you should have a conservative portfolio with less than 30% in equities and the rest in fixed income. While the financial planner might suggest increasing monthly SIP (Systematic Investment Plan) contributions, they will be forced by your age and low-risk-tolerance status to suggest that you can live a “decent” lifestyle with whatever corpus you can realistically build with such an allocation. This would be a significantly compromised lifestyle as shown in the earlier articles.

Let us decide to increase our risk tolerance. Easier done than said. So how do we go about it? The mantra we will use is “Knowledge Overcomes Fear”. The more you know and understand about equities the more risk tolerant you are likely to become over time. Let us begin.

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What are the risks of investing in equities?

Stock markets go down by 10%-30%. In times of crisis even 50% to 70%+. Markets can remain down for 1-2 or 3 years. Sometimes for more than 10 years. A know-nothing investor can lose all their money in the markets. Many well-known stocks can also go to zero. No one, not even the most famous fund managers you might see on TV or read in print, knows when the market will go up or down and by how much.

With assets like these who needs liabilities.

They say that too much debt can make you go broke. With above risks in equities, it would seem that you don’t need debt to go broke. And there are numerous examples of very famous fund managers going broke. Of course, they were traders and NOT investors. Keep those words in mind. We will come back to them later. But remember, most traders—and I mean nearly 99%–lose money, most investors make money. Now that we have established that the risks in equities are high, let us look at the rewards.

Now let us look at the returns and rewards of equities.

S&P 500 was launched in March 1957 with an initial value of around 42. Currently, it is 4181, nearly 4200. That is 100 times in 64 years which is a return of nearly 7.5% p.a. This is without the dividends. Including dividends, the S&P 500 total return index is now nearly 8700. This gives a return of around 8.5%. Based on Prof. Damodaran’s data, the S&P 500 total return including dividends from Jan. 1928 to Dec. 2020 is nearly 10%. All these are returns in USD.

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Sensex began with an initial value of 100 in April 1979. Currently, it is at 48782, i.e. nearly 487 times in 42 years. The annual return or CAGR is nearly 16%. With dividends reinvested the Sensex total return index is at 72199, i.e. nearly 722 times in 42 years. This is nearly 17% CAGR (compounded annual growth rate).

Sensex in USD, called Dollex will be more useful in comparing US market returns represented by S&P 500 with Indian market returns represented by Sensex/Dollex.

Dollex today is 5408. Starting with a value of 100 in April 1979 that is a return of nearly 10% in USD terms.

Given that the INR depreciates somewhere between 2-6% over the long-term and nearly 3% in the last couple of decades, we can assume that both Sensex and S&P 500 have generated approximately 10% returns in USD and 13% in INR.

We have done calculations in the earlier articles with a conservative assumption of 10% in INR terms from equities. Slight increases in actual returns above this could result in significantly higher corpus when compounded over long periods of time. However, while planning one has to be conservative and any returns generated beyond the assumptions are a huge bonus and act as a margin of safety if there was some unaccounted liabilities or expenses in the financial plan.

A 10% compounded return means wealth doubles in 7 years. A 13% compounded return means wealth doubles in 5.5 years. One can use the rule of 72 to estimate the value of ones corpus over different future time frames. For example, with a 10% return, INR 6 crore in 10 years requires a starting corpus of around 2.5 crores. With a 13% return, an initial 1.5 crore could generate around 6 crores in nearly 11 years. With 15% returns, it would take only 10 years to achieve the same.

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You can now see the power of equities even with conservative assumptions which are below the long-term returns of the headline indexes like S&P 500 and Sensex. With higher returns and longer time frames, one could generate great wealth.

Of course, we have laid out the risks earlier before sharing the potential returns and rewards. Now, at least, you know that it is worth developing the risk tolerance for equities, rather than just telling yourself and your adviser that you have a low risk tolerance and hence will not invest in equities.

In future articles, we will share more ways of understanding and getting comfortable with the risks and hence enjoying the joys of equities. Remember: Knowledge Overcomes Fear.

Disclaimer:
Equity investments are subject to market risks. Global investments entail currency and country risks. The above is not a recommendation to buy, sell or hold any of the stocks or sectors mentioned. We and our clients might have exposure to the above-mentioned stocks or sectors. Please consult your investment advisor and assess the suitability of investment products for your circumstances before investing.



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