The problem with historical returns

What is the most commonly heard refrain about the stock market these days?

My guess is that a lot of people now believe that the stock market is a nasty, volatile place where a serious investor cannot make any money. It is a place for gamblers, traders and at best for the short term investor. It is not the place where you invest your retirement money.

One cannot blame the common man for this view. The recent history of the stock market has only re-enforced the above viewpoint. The problem however is that recent history is a poor guide to the stock market or as a matter of fact for any asset returns.

Some historical numbers

Let’s look at some numbers.

The sensex went up roughly from 1300 levels in 1991 to 4000 in 2000. This gives us an average annual return in the 10-12% range. The sensex then rose from around 4000 to 20000 in the next ten years, returning around 17.5% per annum.

These returns are very impressive and also completely meaningless. These numbers hide more than they reveal. These numbers hide the fact the stock market returns are lumpy and do not come in smooth even intervals. None one made an even 17.5% per annum return during the period from Dec 2000 to Dec 2010.

Let’s break down this period as follows

Dec 2000 – Dec 2003: Index went from 3973 to 5838 (13 % per annum)

Dec 2003- Dec 2007: 5838 to 20286 (36% per annum!!)

Dec 2007 – Dec 2010: 20286 to 20509 (around 0.4% per annum)

As you can see, the returns have been lumpy and were concentrated in the 2003-2007 period.

How does the common investor behave?

Imagine an investor in 2007, who has always invested in fixed deposits, gold or real estate. He has been watching the stock market for the last 4 years and has seen the stock market rise by 300%. He is watching his friends and relatives get rich. At the same time, every time he or she visits the bank, the nice personal banker tries to push the hot mutual funds of the day by showing the fantastic returns of these funds for the last 3 years.

If you were looking at the data in 2007, it looked fantastic no matter how you sliced and diced it. The 1, 3, 5 and 10 or 20 year returns looked good.

So let’s say you got taken by the historical returns and went and bought a whole bunch of mutual funds and stocks. What happened after that?

Dec 2007 – Dec 2011: 20286 to 15454 (- 5% per annum for next 4 years)

Ouch!!!

What is the general perception now?

I have been reading quite a bit of the analysis that the stock market is a bad place to invest. Even if you are a long term investor and were invested for the last 3, 5 or 10 years, other asset classes such as fixed deposits would have beaten the stock market at a much lower risk.

I find this argument shallow and intellectually lazy.

The problem with this argument is that the person making this argument is doing data mining. He is slicing the data in such a way that it just proves his point and does not really highlight the main point about the markets

So what are the main points?

I would say there are several points worth remembering

1. The stock market is a volatile place and returns come un-evenly. As you saw from the data above,  past returns have not been smooth fixed deposit type returns, but lumped in short periods of time.
2. Valuations matter! If you buy at high valuations (dec 2007) and sell at the time of low valuations (say Dec 2009), you will lose money. Period!
3. The stock market is a risky place. There will be long periods of time where you will not make money or even loose money. At a point when everyone is pessimistic or has given up, the stock market has a tendency to turn and surprise everyone. The same holds true at market peaks too.

Other asset classes

Let’s look briefly at some other asset classes.

Gold (all prices in dollars per troy ounce)

1971- 1981: 40 – 460 (25% per annum)

1981 – 1991: 460 – 362 (-2 % per annum)

1991 – 2001: 362 – 271 (-3 % per annum)

2001 – 2011: 271 – 1571 (19% per annum)

As you can see from the above numbers, gold seems to have followed a similar trajectory. There have been periods of high returns, followed by long periods of dismal returns (40 year returns have been around 9.5% per annum)

I don’t even consider gold as an investment as it does not generate any cash flow and is merely an insurance against armageddon or end of the world scenario. But I think I am in the absolute minority, considering the fact that Indians are the largest buyers of gold and absolutely love this metal. So in the end, one cannot really put a price on love!!

I don’t have the numbers for real estate, but anecdotally real estate has displayed a similar pattern. The returns were poor from 1993 to around 2003. The major gains came from 2003 to around 2008 and now the real estate market has slowed down considerably.

You will definitely find examples, where someone purchased a piece of land outside the city and was able to get 10X his or her investment. However a single multi-bagger is not representative of an entire asset class.  That’s like saying that as Hawkins cooker went up by around 1600% in the last 5 year, the entire stock market should also have done well.

The curse of past returns

I am not optimistic that the general, un-informed investor is going to change any time soon. The majority of investors are hard working, middle class people with busy lives. Investing and  the stock market is the last thing on their mind. The time when the market does catch their attention, is when it has gone up considerably. As a result, most of the retail investors end up entering the market at precisely the wrong time.

Past returns are a good starting point to evaluate the long terms returns of an asset class. However these returns are not written in stone. The best approach to evaluate the likely (not guaranteed) returns one will make, is to calculate the expected returns at any point of time and make buy or sell decisions accordingly. The topic of expected returns is however a much more complex topic, and possibly one for a future post.