Can equity be a fearless investment option?

The greatest enemy of any investment is inflation. In the developing economy like us we have to live with high inflation.  When we talk about inflation its not just CPI or WPI numbers as published by the government every month but there are various other services like what we pay to doctors, school fees, barber etc. which are not covered in the index but has a very significant impact on our investments and savings. It means that the inflation-adjusted interest rates that we earn from fixed-income investments like deposits etc are actually negative when compared to the real inflation rate that consumers face.

  

This inflation is due to structural and demographic reasons and could not be solved in a very short period. Hence it could be years before we get positive real returns from fixed income securities (FDs, bonds etc). In this scenario equity is one of the assets that has the potential to beat inflation to earn real returns. It is for this reason that we should have a significant exposure to investments in equity in any of the investment portfolio.

However when we talk about equity investments any normal investor’s first reaction is that it is risky. The risk of losing money is more dominant than earning and keeps most of the investors away. Further short term ups and downs and coverage by print and electronic media gives the impression that the investments will always be moving ups and downs without giving any stable returns. As the stock market goes up brings lot of happiness with the investors on the other moment as it falls they get devastated.

However when we talk about equity, this volatility is an illusion. How can this be? How can returns from a type of investment that is volatile be high and safe. The answer is to understand that the same thing can look very different at different scales.

Let’s take an example of a man playing with a yoyo going upstairs. Everyone watches the yoyo which is moving up and down but does not see that the man carrying the yoyo is actually going up. Similarly in reality, the returns from equity are not only high but they are quite safe too.

Let’s take another example. What is the coast line of India? The official answer is 7,517 km. But will everyone have the same experience awhile covering the entire coast line. from Gujarat to West Bengal. If an ant walked the entire distance, would it come up with the same answer as a man will walk through? And how about an aeroplane covering the same distance?.

In each of these cases the answer would be very different. The ant may come up with an answer thousand of km higher because it would follow each nook and corner of the coast at the scale of millimeters. A human being would follow it on a scale of feet and come up with a lower answer. An aeroplane would follow it only on the scale of many kilometres and would come up with a far lower answer.

Stock market volatility is a bit like this. If we track the markets everyday, we will see many ups and downs. If tracking it once a month, there will be fewer ups and downs. On the scale of an year, the ups and downs would be even fewer and if we look at the markets only once every two or three years, there would hardly be any volatility. Now, imagine the scenario once in a decade or for even longer periods.

Let’s see the two charts below. One is that of the BSE Sensex' daily movements from 1990 to 2015. The other is the same time period, but marked only once in five years!

The first graph can put the most intelligent and smart  investors also in a difficult and worrisome situation. However, the second graph is very smooth and shows practically no volatility.

For example is we had invested in stock market in 1990 and then checked the investments only once in five years, then sometimes it might have risen more and sometimes less but would have given positive returns most probably. Over longer time such as a decade or more, the movement of Sensex evens out, thereby reducing volatility in reality.

Like we cannot cover a 5000 km distance by a cycle but an aeroplane whatever risk it may look like similarly to cover our bigger financial goals over a longer period of time, equity is the best option.

The message for the investors is: that investing in stocks can lead to frequent losses only if we are a short-term trader. Over sufficiently long periods of time, it is  like aeroplane flying over the coastline. The little twists and turns that vex the ant are not your concern. But do we need to invest in equities directly? Its not required if we are not experts its always better to taken the services of experts. So to invest in equity sensibly and make money out of it, there's no need to actually get into stocks and shares ourselves--equity mutual funds will do the job for us.

How to evaluate various Investment Options

When we are investing money it means we are parting away our cash to someone for future incomes. There are three ways when an investment gives us a money:

1.       Giving money as a Loan. In this case the loan giver or Lender gets some fixed interest (some time variable interest also depending upon the terms and conditions) from borrower and also his capital investment at the end of the tenure. Here normally the returns are fixed.

2.       Become a partner in some business. Means buying shares of a business and receiving the profit share on this business. We may get a handsome profit or nothing depending upon the nature and performance of that business.

3.       Buying something whose value can appreciate in the future. Like Gold, Paintings, Land etc.

Any investments will be classified in these three terms either individually or jointly with others. But the basics will remain within these three parameters.

• So when we are lending money means like buying bonds and making Bank Fixed Deposits there is fixed return from the investments and will not be dependent on the performance of borrowers business. No matter how successful that business may become, our returns will remain fixed as decided at the beginning.
• When we are buying shares means we are part owner of that business and accordingly bear the risk and reward of that business. If business does well we earn handsome dividend and may be the value of the business also goes up, however if its doing bad we have to bear the losses also. In this case the risks are high, and the potential of reward is also high.
• In the third kind of investments it’s purely the future price of that asset, if it goes up we earn profit and if it goes down we may lose money. Here the demand supply also plays a vital role on the value of these assets. Higher the demand and lesser the supply will lead to rise in value and vice-versa.

In investing jargon, the first type (lending) is called debt, or fixed income investing. The second type (owning) is called equity investing, with stock or shares being synonyms for equity. The third one is called owning physical assets. Almost everything that we invest in can be classified as one of these asset types. For example, bank deposits or company deposits are debt while buying shares or investing in equity mutual funds is equity. While buying gold would be called as owning physical assets.

While there are a lot of ways in which investments differ from each other, there are three basic characteristics that define any investment:

Risk: The likelihood of an investment not fetching the return we expect from it.

Returns: How much returns does the investment fetch actually.

Liquidity: Whether we can withdraw our money at any time.

Each of these three factors have some nuances to them. To start with Returns, when someone invests money his main objective is to get highest possible returns with minimal possible risk. However, normally, higher returns come with higher risk. Again, the defining example of this is the debt to equity comparison. Debt investments have less risk and low returns but equity can have higher returns with higher risk. There are huge variations within equity and it’s perfectly possible to have higher risk as well as poor returns. In fact, that’s what most careless or overconfident equity investors actually get.

Risk can be defined as the likelihood of loss, or the likelihood of not getting the expected return. Generally, debt has the lowest risk and equity the highest. However, there are many variations to this idea. For example, debt investments in failing businesses (Bank’s Loan to Vijay Mallya is the latest example) can be very risky while on the other side there are many ways of managing risk levels in equity.

Liquidity is about getting your money back on demand. For example, if we keep our money in a savings bank account, we can walk into any ATM anywhere in the world and immediately withdraw it, subject to some limits. If we go into a bank, we can withdraw all of it. In some investments, there could be a penalty for liquidity. In a fixed deposit, either we have to wait for the whole term, or settle for less returns or pay the penalty. In equity shares, liquidity varies from stock to stock. Big Company’s shares could be bought or sold at any time for any amount however for small companies it may not be that easy. For physical assets the liquidity and value depends on demand and supply of that asset. For example the paintings of Leonardo da Vinci will always fetch high price due to two factors one is the quality of painting and secondly now the painter is no more so there is no further supply of paintings from the creator and hence limited existing supply.

While deciding about the investment we have to keep it in mind about these factors and may distribute the portfolio among all of them so as to diversify the risk as well as get the returns from all prospective options.