We all agree on the fact that over the long run, Equity as an Asset class always beats FD return. Of course you have to pay for the extra return in terms of Volatility, riding through booms & the busts. Sensex (as a basket of top 30 Indian companies) was formally started in 1979 with the base price of 100. As I write this, Sensex closed at 38,645.18 today, a solid CAGR of 16%.
Astonishing! Isn't it? And this is CAGR of dumb Index whose members are selected just based on Market Cap. Those who were lucky to lay their hands on few of the multi-baggers, are financially independent now. So, if someone during 80s wanted a return of 16%, all he had to do was to buy the Sensex.
So, what what the reason of this mind-boggling return? And what if I am starting today? What is the guarantee that I will enjoy the similar return in future also? Aren't mutual funds repeatedly saying that past returns are no guarantee for the future?
Well, I am not going to get into usual jargon like India as a developing country has a long runway for growth or Modi's revival of economy to aid hyper-growth. Let me present you the logical reason for the higher return of Equity.
Suppose, bank gives you interest on FD @7%. The entrepreneur (or business man) takes loan from bank at rate say @10-12%. So the business man has to do only such a business that with certainty earns a return greater (say 14-15%) than the bank interest rate. If this condition is not met, then the depositors money in FD is not safe. When an industry starts earning an ROI which is even less than the cost of capital (simply say borrowing rate), then it certainly is a ticking bomb. We have witnessed several such examples in the form of defaulters like Kingfisher Airlines, Bhushan Steel, Alok Industries and now Jet Airways. So, if we assume that our money is safe in the bank; by the same hypothesis Industries will keep generating returns higher than that of the bank.
There are 3 forces which try to hold this hypothesis of Industries earning return higher than the deposit rate.
First entrepreneur himself. The business man (the captain of the ship) will give his blood and sweat to make his venture successful (read earning high ROI). Captain is always the last to abandon the sinking ship.
Secondly RBI, whose primary job is to keep the financial equilibrium (supply/demand) intact by cutting/raising interest rate. When businesses start under-performing due to economic reasons, RBI intercepts and lowers the interest rate. This eases the interest burden of businesses. At the same time, common man (depositor) gets more purchasing power leading to more consumption; in turn facilitating more sales and earnings for businesses leading to higher rate of Industry return.
Thirdly, during adverse economic conditions or slowdowns, Government interferes and provides support to businesses like free land, discounted spectrum, free landmines, tax rebates etc. So that job losses can be contained and depositors money remains safe in he bank for the overall stability of the economy.
In worst case scenario, even after these efforts, Industries are under performing, then few companies will close down. This leads to reduced supply (and high demand). Remaining companies now enjoy less competition and will raise prices to earn more than their borrowings.
Now think hard! So many unfavorable events happened between 1979 and 2019. Harshad Mehta Scam of 1992, Ketan Parekh Scam during late 2000, US Housing Crisis of 2008, BREXIT, LTCG, majority Governments, coalition governments; market has endured all. In spite of all these, market return was impressive and you know the science behind it now.
Hope now you have an assuring reason to repose you faith in Equities. You also now have something to explain to that friend of your father who keep pestering you for an LIC endowment policy! Next time you meet that uncle, pull out the Excel and show him the XIRR ofthe policy.
Happy Investing. Good Night!
Astonishing! Isn't it? And this is CAGR of dumb Index whose members are selected just based on Market Cap. Those who were lucky to lay their hands on few of the multi-baggers, are financially independent now. So, if someone during 80s wanted a return of 16%, all he had to do was to buy the Sensex.
So, what what the reason of this mind-boggling return? And what if I am starting today? What is the guarantee that I will enjoy the similar return in future also? Aren't mutual funds repeatedly saying that past returns are no guarantee for the future?
Well, I am not going to get into usual jargon like India as a developing country has a long runway for growth or Modi's revival of economy to aid hyper-growth. Let me present you the logical reason for the higher return of Equity.
Suppose, bank gives you interest on FD @7%. The entrepreneur (or business man) takes loan from bank at rate say @10-12%. So the business man has to do only such a business that with certainty earns a return greater (say 14-15%) than the bank interest rate. If this condition is not met, then the depositors money in FD is not safe. When an industry starts earning an ROI which is even less than the cost of capital (simply say borrowing rate), then it certainly is a ticking bomb. We have witnessed several such examples in the form of defaulters like Kingfisher Airlines, Bhushan Steel, Alok Industries and now Jet Airways. So, if we assume that our money is safe in the bank; by the same hypothesis Industries will keep generating returns higher than that of the bank.
There are 3 forces which try to hold this hypothesis of Industries earning return higher than the deposit rate.
First entrepreneur himself. The business man (the captain of the ship) will give his blood and sweat to make his venture successful (read earning high ROI). Captain is always the last to abandon the sinking ship.
Secondly RBI, whose primary job is to keep the financial equilibrium (supply/demand) intact by cutting/raising interest rate. When businesses start under-performing due to economic reasons, RBI intercepts and lowers the interest rate. This eases the interest burden of businesses. At the same time, common man (depositor) gets more purchasing power leading to more consumption; in turn facilitating more sales and earnings for businesses leading to higher rate of Industry return.
Thirdly, during adverse economic conditions or slowdowns, Government interferes and provides support to businesses like free land, discounted spectrum, free landmines, tax rebates etc. So that job losses can be contained and depositors money remains safe in he bank for the overall stability of the economy.
In worst case scenario, even after these efforts, Industries are under performing, then few companies will close down. This leads to reduced supply (and high demand). Remaining companies now enjoy less competition and will raise prices to earn more than their borrowings.
Now think hard! So many unfavorable events happened between 1979 and 2019. Harshad Mehta Scam of 1992, Ketan Parekh Scam during late 2000, US Housing Crisis of 2008, BREXIT, LTCG, majority Governments, coalition governments; market has endured all. In spite of all these, market return was impressive and you know the science behind it now.
Hope now you have an assuring reason to repose you faith in Equities. You also now have something to explain to that friend of your father who keep pestering you for an LIC endowment policy! Next time you meet that uncle, pull out the Excel and show him the XIRR ofthe policy.
Happy Investing. Good Night!
XIRR Calculation in Excel
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