July 2018: Lower market volatility may lead to greater equity allocations

As fixed deposit rates have been low in recent years and returns from real estate investments have been poor, we are seeing investors allocating more towards equities in their asset allocation. The returns from the Sensex since 1985, have been about 13% pa. If one had invested Rs 1 lakh into the Sensex in 1985, it would be worth Rs 67 lakhs now. Whereas the same Rs 1 lakh invested at 7% pa in a fixed income instrument would amount to Rs 9 lakhs in today’s rupees, without factoring the impact of taxes which favors the argument for equities even further. Despite there being such a vast differential in terms of returns, over long periods of time, a very large proportion of the average Indian investors’ savings continues to be in fixed income, even though it is invested for the long term.

Probably the single biggest reason for this irrational behavior is the volatility in equity market returns. While most people acknowledge that returns from equities are likely to outstrip fixed income returns over the long term, what pushes them towards fixed income is a lack of knowledge about inflation adjusted returns, which for fixed income, on a post-tax basis is very low and also the variability or volatility in equity market returns, which tends to scare people off.

There is some good news on this front. Volatility in the Indian equity market has been coming down. Over the last 25 years that we have been analyzing the Indian equity market, we have observed a trend of greater maturity in the Indian equity market. While this is not the strict definition of volatility, we are measuring volatility, in simple terms, based on high and lows of the market in each year – say if the Sensex trades at low of 100 and a high of 150 in a given year, we then measure volatility as 50% (150 upon 100). In the 20 year period from 1993 to 2013, the average annual volatility in the Sensex was about 60%. In recent years, average volatility has come down to under 30%. It is difficult to say if volatility will spring back to past levels, but one needs to view this in the context of volatility in developed markets. This figure is about 24% pa in mature markets like US. In our opinion, it is fair to assume that investors will have higher confidence to invest in equities – especially when long term returns in equities are better than fixed income – if volatility in equity returns is low.

Reduced volatility is the outcome of an increased depth and breadth of the markets. Over the years, the Indian market has become larger with total market capitalization at close to $ 2.2 trillion now. Also, the variety of companies to invest in, is expanding, thanks to an active IPO market. In recent years, we have seen a number of different kinds of businesses getting listed on the bourses. Some examples of this are asset management, insurance, stock exchanges, depositories, retailing, pathology labs. Though services accounts for a significant proportion of GDP, it has been under represented in the equity market – we are slowly seeing services finding greater representation. Multiple classes of investors can also help reduce volatility. For example, we have seen recently that the selling of foreign investors has been absorbed by the increased inflows into domestic equity mutual funds and insurance companies.

Our objective, while managing portfolios, is not only to maximize overall returns, but also to reduce the volatility of those returns. Reduced volatility gives investors more comfort in investing a larger proportion of their wealth in equities, which we believe is the right thing to do, for the long term.