Setting returns expectations
A good investment plan starts with setting the expectations right. The importance of this grows multifold in this informative age, where social media platforms’ feed is filled with people finding multibaggers, doubling the investments in a matter of a few months, etc. Investors with higher expectations tend to quit markets once reality hits, and join conservative FD pool.
Over optimistic investors tend to save little and hence might fall short of the investment goal. Over pessimistic investors tend to save too much at the cost of present because of lower expectations. Hence, as an investor it’s utmost important to know what is expected with reasonable certainty from the investment.
We tried to take a data-driven approach to answer what is the reasonable expectation range. A simple investment plan can be a blend of Equity and Fixed deposit. Hence, We have looked at the last 42 years data of sensex returns, and FD rates of 50 years.
If we look at year-wise data of sensex returns, 30% of the times investors ended up in losses. Successful investors say that buy and hold strategy works better in stock markets. So, we have looked at 5 year and 10 year rolling returns during the same period. The hypothesis is consistent with the historical returns. The chances of experiencing loss in a 5-year period has reduced to 10%, and to only 1% in the case of a 10-year investment period.
The above graph clearly shows how volatile short-term returns are. We can clearly spot two trends:
- The range of returns is getting condensed as the investment horizon increases
- The negative returns have gone down as the holding period increases
| Investment period | Standard Deviation | Average Return (CAGR) |
|---|---|---|
|
1-Year |
35% |
17% |
|
5-Year |
10% |
11.3% |
|
10-Year |
5% |
11.4% |
We have looked at Standard deviation to get a better sense of volatility. Standard deviation decreases significantly as the investment period increases. Averages can be misleading as it doesn’t capture the risk involved. If someone looks at only average returns in the short-term, they are likely to set wrong expectations on returns.
One has to be aware of risk free return before investing in equity. If risk free return in the market is 6% and the investor is looking for 6% returns, then it’s a clear choice to invest in Fixed income because of lower risk compared to equity. Fixed income returns are shown in the below graph (source RBI). Returns have varied from 4.6% to 12%, with average returns standing at 8%.
If the investor is looking for higher returns than Fixed income returns, then the element of risk comes into picture. As shown in the sensex returns graph, returns tend to vary a lot year to year. The volatility goes down as the holding period increases. Hence, it’s easier to predict next 10-year returns compared to predicting next year returns.
Some might get disappointed after looking at an average CAGR of 11.4% over a 10 year period. They need to understand the power of compounding. A CAGR of 11.4% over 10 years is 2.9X of investment, but over 30 years it is 26X of the initial investment. Investors with proper risk management, reasonable expectations, and a longer investment horizon benefit from the power of compounding.
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