When stock market returns lie!

Dr Uma Shashikant, PhD in finance, is a well-known Knowledge Management Consultant in the capital market. She will write a column every month that will tell you how to look beyond the numbers when investing.  

As the Sensex inches upward, everything looks hunky-dory. In fact, many have convinced themselves that just a year in the stock market is sufficient to earn great returns. 

Even those who think long-term find themselves in a nice position. Just look at the historical returns: Five year returns for the year ended December 31, 2005 are 18.73% while the three year returns are 40.34%.

Most diversified equity mutual funds have given returns higher than the Sensex and their historical returns, despite the disclaimers, look large enough to get investors interested.

It is obvious investors have begun to believe that good returns from the equity market should be in the 40% plus region, and that number is not too tough to achieve.

That is indeed the impact of few good years!

It is not as if the yearly return on the equity market has remained at 40% plus. It is just that the bullish trends create expectations of better returns, because we view the market from that high point and look back with a sense of satisfaction.

Where you stand virtually determines what you see.

Confused? Let me explain. 

Consider this table on stock market returns.

Year Ended: This column refers to where you choose to stand. It is the end point. You view all returns keeping this as a reference.

Let's say you pick December 31, 1992, as the reference point. If you invested three years prior to that, your returns would be 49.76%. But, if you invested just one year prior to that, your returns would only be 37.01%. If you invested 10 years prior to that, your returns would drop to 27.20%. The same investment, the same reference point. Yet the returns fluctuate if you take different time periods.

 The table above teaches us a few important lessons.

1. If the end point (picked as the reference point) is high enough, it is sufficient to make everything else in the past look nice. When it comes to stock market returns, the bias comes with the end point. 

2. If the end point is during a bull phase, the return expectations, even for the long run, can be way above normal. In 1992, for example, people would have seen a 10-year return of 27.20% and felt great about it.

3. The risk in the market is about these values fluctuating widely. What is the 10-year return to expect based on past experience? If December 31, 2001, is the reference point, then the number is 5.51%. If December 31, 1992, is the reference point, the number is 27.20%. 

The moral of the story is that returns from equity fluctuate widely; it is important not to fall into the trap of expecting too much, standing on a new high of the index and looking backward.

Suppose we decide to slice the bull run, year by year.  We would end up with a radically different picture.

Let's look at how the Sensex has performed every single year.

Year-on-Year returns of the Sensex: December 1980 to December 2005.

The returns are categorised into six slots depending on returns (100% to 80%, 80% to 60%, 60% to 40%, 40% to 20%, 20% to 0%, 0% to -20%).

If you had invested in the market in 1994, you would have got returns in the vicinity of 80% in 1995. But, if you invested in 1995, the next year you would have lost heavily.  

Click here to view a larger image.

The quiet confidence from last year's return numbers would convert into a concern, if we recognise this picture as the return possibilities from the market.

Consider these learnings.

1., The actual returns fluctuate by a very large margin every year. So, a good market does not take away the risk from investing in equity.

2. Good years and bad years can come in randomly. There is no fixed pattern. That 2005 was a good year does not necessarily mean 2006 will be even better.

3. It also highlights the fact that buying shares just because the past looks good represents the highest risk. All the abnormally high columns in the picture are followed by smaller, or even negative columns.

Therefore we cannot walk into 2006, expecting 40% returns. It could be higher or lower, and past data will not help us predict it.

It is not as if we are protected from these risks the moment we switch to equity funds. The end-point bias applies to funds as well.

What can we do to tone our expectations down to realistic levels?

1. Don't blindly choose funds based on past numbers. Look at the fund manager's return year on year to see how he had done each year, in comparison with the index.

2. How has the fund manager fared against the index every year is what we should look at rather than satisfy ourselves about him having beaten the index in a good year. 

3. We also need to ask what kind of equity risk we are willing to take.

If consistency is what we like, the equity market may not be the place.  But if we like the high returns of the equity market, we need to stay in it for the long term. Long enough to be able to have at least few good years in our bag so that the bad years don't hurt too much. 

4. When we like to choose equity or equity funds for their return, we must make sure we understand the risk beneath the numbers, keep expectations realistic, and stay invested during good times. 

Bull markets do not reduce the risks for investors, though they appear as if the money is there for the taking.

Dr Uma Shashikant is the Chief Research & Development Officer, OptiMix, a multi-manager division of ING Investment Management India (Pvt) Ltd.