Stock Market Reality Check: How Much Returns Can You REALLY Expect?

[ad_1]

Listen to this article

Have you ever felt the exhilarating rush of the stock market, only to be met with crushing disappointment when your investments fall flat?

You’re not alone. Many investors are left scratching their heads, wondering why their portfolios haven’t mirrored those incredible headlines boasting 15% gains or more.

Where did those expectations even come from? Were they based on rumors, a lucky stock pick, or simply wishful thinking?

The truth is, relying solely on these factors can lead to a rollercoaster ride of emotions and leave you questioning your entire investment strategy.

This article is your guide to navigating the often-murky waters of stock market returns. We’ll help you ditch the unrealistic expectations and set achievable goals for your investments. We’ll show you how to craft a personalized return target that goes beyond past performance or financial hearsay, and how this crucial step can empower you to build a rock-solid investment plan for the future.

So, are you ready to ditch the frustration and take charge of your financial journey? Let’s dive in!

What exactly are “Realistic Expectations” for Equity Returns?

When you’re dealing with your entire investment portfolio, whether it’s in mutual funds, stocks, or a mix of both, it’s crucial to have an idea of how much you expect it to grow as your goals are directly linked to these expected returns.

To achieve your financial goals, you need to know how much money you should save. This involves understanding the concept of “returns,” which indicates how much your investments could increase over time.

However, determining the exact return rate can be challenging. Sometimes, people simply choose a number based on what sounds good or what they’ve heard about historical market performance.

For example, some might opt for a return rate between 15% to 20% because it seems appealing and because they’ve seen such returns in the past. However, relying solely on these idealistic numbers can lead to problems.

What do NIFTY’s Rolling returns show us?

For instance, let’s see the rolling returns of the NIFTY 50 over the 5-year timeframe (as of July 2023).

Source: https:www.advisorkhoj.com

Historical market data reveals that while there have been periods where returns reached 15%, there have also been instances of negative returns. For instance, during March 2020 and across the period from 2015 to 2020, there were multiple years with negative returns, totaling five years.

Additionally, there have been numerous occasions where returns remained in the single digits.

When extrapolated for the entirety of the index, over 70% of the time the return did not meet the 15% threshold. This indicates a significant likelihood that expected returns between 15% to 20% may not materialize always.

Now that we know these arbitrary numbers won’t work, let us try to understand whether we can base our return expectation on other factors and metrics.

What are the other Alternative methodologies for Equity Return Expectations?

Now that we know that you shouldn’t base your entire return on mere numbers, let’s bat an eye on some other methodologies.

1. Real Returns

Let’s consider something called “real returns,” which the erstwhile RBI manager Raghuram Rajan had talked about in his lecture at the Tata Institute of Fundamental Research, back in 2016.

This is how it goes.

Anything higher than retail inflation can be accounted for as the real return and the aim for us is to make at least 2 % in addition to the rate of inflation.

So, to get into the depth of this we need to understand inflation over the last few years.

Source: https:www.macrotrends.net

The above chart shows the returns of the CPI over the last few years.

So, our objective is to think of some instrument where it can give a 2% higher return than this inflation.

Sometimes, FDs give us 7%, which may be about 1.5 to 2 percentage points more than inflation. So, it may be a fair return on investment in this period.

If you’re investing in something riskier, like equity, you might aim for 4 to 5 percentage points more than inflation.

Source data from : https:www.macrotrends.net

Do note that the extent to which the market has outperformed inflation has fluctuated a lot from 2007 to 2023. High inflation isn’t favorable for the economy or stock markets to excel, and similarly, low inflation doesn’t provide much assistance either.

Number’s Game : Using Inflation data to arrive at Equity returns:

Let’s delve into the numbers and examine how the latest inflation figures influence equity returns.

As of March 2024, the Consumer Price Index (CPI) stands at around 5.2%. Typically, an investment yielding at least 2% above this inflation rate is deemed fair.

However, for riskier assets like equities, investors often seek an additional 4-5% return on top of inflation. Hence, expecting a 10% return is reasonable.

It’s essential to note that inflation is dynamic, influenced by various factors. Over longer periods, and considering compounding returns, equity investments could potentially yield around 12%. This forecast accounts for the dynamic nature of inflation and the risk-return profile associated with equity investments.

By understanding the relationship between inflation and equity returns, we can make informed decisions aligned with their financial goals and risk tolerance.

2. Equity Risk Premium

Imagine you have some money to invest, and you’re trying to decide between two options:

Putting your money in a government bond
Buying stocks in the stock market.

A government bond is like lending your money to the government for a certain period, and they promise to pay you back with interest. It’s considered very safe because governments rarely default on their debt. So, the interest you earn from a government bond is called the risk-free rate because you’re not taking much risk.

When you buy stocks, you’re buying a small piece of ownership in a company. Unlike government bonds, stocks can be riskier because the value can go up and down based on how well the company is doing or what’s happening in the market.

The extra return you hope to get from investing in stocks, compared to the safer government bond, is called the equity risk premium. It’s like a bonus you expect for taking on the extra risk of investing in stocks instead of bonds.

So, in essence

Risk-free rate + Equity premium Risk =Expected Equity Market returns

Source: RBI Bulletin on Equity Risk Premium

For example, during a financial crisis like in 2008 or during the COVID-19 pandemic in 2020, people were really scared about losing money in the stock market. So, they wanted a higher premium for investing in stocks.

On the other hand, when everything is going well in the economy and the stock market is doing great, people might be more confident and willing to accept a lower premium for investing in stocks.

So, the equity risk premium helps you understand how much extra return you might expect from investing in stocks compared to safer investments like government bonds, thereby helping us set an expectation of our future returns.

This is all about ERP (Equity Risk Premium) in simple terms. But when you drill down to the granular levels ERP is influenced by a multitude of factors and past data may not play out in the same manner. You can check out the whole rationale on ERP here by Aswath Damodaran. The below image is an excerpt from his blog on how exactly the ERP is being influenced.

Crunching the Numbers: Using ERP to forecast the Equity returns:

Let’s calculate the real return expectation based on the given information.

Assuming the risk-free rate, which is typically represented by the interest rate on government security bonds , as 7%, and the equity risk premium (ERP) generally hovering 4.2%.

So, according to the formula:

Expected Equity Market Returns = Risk-free rate + Equity premium Risk

Expected Equity Market Returns = 7% + 4.2% = 11.2%

This means that historically, investors have expected a 11 % return from investing in the stock market, considering the additional risk compared to government bonds.

However, it’s essential to note that the actual returns can vary based on various factors such as economic conditions, company performance, and market sentiment.

During tough economic times like the 2008 financial crisis or the 2020 COVID-19 pandemic, investors want more reward for taking risks in the stock market. But when the economy is doing well, they’re okay with less extra reward.

So, let’s say during tough times, they want 7-8% extra, and during good times, maybe 3-4% extra. Overall, when you look at it over a long time, it balances out and we get the return around 11-12%.

3. Nominal GDP Growth & Stock Market Returns

This might sound very simple, but trust me, Nominal GDP Growth is a very reliable indicator.

This concept combines two things: real GDP, which shows how much a country’s economy is growing, and inflation, which measures how prices are rising. When you add these together, you get the nominal GDP, which reflects the overall growth of the economy.

By looking at how the nominal GDP is growing over five-year periods, you can see a pattern. It turns out that the returns from investing in the stock market during those same five years are pretty similar. In other words, when the economy is growing, the stock market tends to do well too.

But there’s a twist. Sometimes, the stock market can take a nosedive even if the economy is still okay. For example, in March 2020, the stock market plummeted even though the economy hadn’t crashed yet.

Source: https://www.ceicdata.com

But on average, if you crunch the numbers, you’ll find that nominal GDP grows by about 10.7%, and the stock market grows by about 12-12.2%. If you’re willing to take on more risk, you might see even higher returns. However, if the economy seems to be struggling, you might not expect much from your investments.

So, the suggestion is to use nominal GDP growth as a guide for what returns to expect from your investments. Anything extra you get beyond that is a bonus.

Remember, if the economy is at a low point, you might adjust your return expectation slightly higher. So, you don’t need to dive into complex calculations; just keep an eye on the nominal GDP growth to guide your return expectations.

What Equity Returns to expect in the upcoming years?

The projected nominal GDP growth for 2023-24 is 9.1%, a decrease from the previous year’s 14.2%. Based on historical trends pre-COVID, equity returns typically exceed nominal GDP growth by 2-3% and one can expect the same in the coming years as well.

However, the COVID period and subsequent years may be regarded as exceptions due to significant economic contraction followed by rapid recovery.

It’s also important to acknowledge that nominal GDP figures are subject to change and influenced by various external and socioeconomic factors. Therefore, while using nominal GDP as a reference for equity return expectations, it’s crucial to remain vigilant of potential fluctuations and uncertainties in the economic landscape.

Conclusion

Now, you need to keep something in mind– returns don’t always hit high numbers like 15 or 20 percent. Those are rare and happen when everything in the economy is booming – like low interest rates, reasonable inflation, and lots of investment. It’s better to keep your return expectation closer to what we usually see, around 10 to 12 percent.

If you’re falling short of your goal, don’t just try to boost your returns – increase how much you’re saving each month instead. That’s something you can control, and it’s the surest way to reach your financial goals. Remember, investing in the stock market comes with risks, so be sure to understand everything before you dive in.

[ad_2]

Source link