What returns do you expect from your equity investment?
We ask this question to retail investors & here’s how many of the conversations happen:
Advisor: What returns are you expecting on your equity investments.
Investor: (without batting any eyelid) 18 – 20% and higher.
Advisor: And why this high number when all you are getting is 7% on your FD.
Investor: I must get very high returns because stock investing is very risky.
Advisor: And how much of your investable surplus are you planning to put into equity?
Investor: About 20%
Advisor: And why only 20%?
Investor: Arrey bhai, bola na. It risky. I can withstand this much loss only. You want more money from me then double this very quickly. Like Manibhai, he doubled his money in less than two years!
Advisor: But that would be very risky!
Investor: I told you, it is risky, but what to do no pain no gain. Risk toh lena padega na.
Now, this may sound a bit exaggerated, but it’s close to what many people new to investing think.
We don’t want to argue about the number, whether it’s right to expect this, whether it’s possible etc. etc. We are sure someone maybe achieving this kind of returns; after all there are some people who do win in the casino and even walk-out with their winnings. These are rare birds. But almost all of us do not fit this description. We simply don’t have the mental make-up, the time, the energy, the talent and the luck to invest in a manner that could live up to our high returns expectation. Worse we will end up investing in a manner that actually increases our chances of failure.
The biggest driver of failure will be taking high risk with the hope of earning high returns. While the risk is real even if sometimes it does not always materialize, the high returns are not guaranteed. The portfolio will be loaded with stocks that are small and micro-cap, even the mutual funds will be mid and small cap funds. Such a portfolio will move up and down substantially with the market
It will be thrilling when it moves up and you may even invest more thinking you really understand these things and it’s okay to take risks. But markets will go through cycles and corrections are steep and fast for mid and small cap stocks. When such corrections happen retail investors go through the stages of denial (it’s temporary, it will go up again), fear and panic before selling at near bottom.
Sometimes a stock specific event occurs for a stock in your portfolio (which is not uncommon for this category of stocks). Then prices fall hard and very rapidly eg 50%. Do you think you will exit the stock immediately? Most retail investors freeze and don’t act and usually are almost fully wiped out.
Why did this happen? Because your expectations of earning very high returns made you susceptible to taking on very high risk. And sooner rather than later, some of this risk materializes and you realize that you are not up to handling it. But is this the only way to invest in equity? No, of-course not. But to follow a different approach that can still work for you needs you to have a very reasonable expectation of returns.
What returns expectations can help you behave in ways that enhance your chances of success?
In the long term stocks will appreciate at the rate at which companies grow their profit or EPS. There are times when the prices rise faster than this. In essence PE ratio rises, known as PE re-rating. This could happen for some specific stocks or for many stocks in general. The reasons differ. However, this tends to revert to the mean based on actual earnings growth. So as far as your returns expectations goes it should be in line with the long term earnings growth rate and not hope for PE re-rating.
With this returns expectation the selection of stocks and the prices you will pay for it will all tend to keep risk low. And if markets are irrationally high you will be comfortable booking some profits and holding money in a Liquid Fund. This reduces risk and also provides you with cash to buy equities when prices become attractive. The other real benefit of this is that when markets correct, your portfolio will correct by a lesser degree, enabling you to stay invested and enjoy the benefit of long term compounding. This return is currently 12-13%.
People tend to think of this as being pretty low and something that should happen anyway, especially when markets are bullish. That’s not true. Markets go through periods of low performance and retail investors usually enter and exit at wrong times resulting in poor returns performance. Having a sensible returns expectations helps you earn returns that are twice that of FDs without losing sleep and that pretty impressive in itself. When the investing approach makes you comfortable you will feel confident about investing your entire investable surplus to earn this returns and that ensure growth in your wealth.
One lac of saving @ 6% will become 3.2 lacs after 20 years, but will become 9.6 lacs @ 12% returns. That’s 3 times more, giving you 6.4 lacs additional buying power beyond inflation for every lac. See it in a different way. Suppose you need to have 5cr after 20 years. You will need to have 1.5 cr today if you earn 6% interest per annum. But you need only 50 lacs if you earn 12% returns. The effect is equally dramatic when you do an SIP that earns you only 6% versus 12%. In short earning 12% returns will make many of your future goals possible.
Read the next article to understand: ‘Know what you want in your life and plan for it’.
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