Equity may be volatile, but it’s not risky in the long term4 min read . Updated: 31 May 2015, 07:11 PM IST
We should understand is that volatility in stocks is not the same as risk
When markets turn volatile, as they sometimes do, avoid panicking. Keep calm, and keep stocking up equity assets. Risk is generally seen as the probability of a loss in any asset class. In finance, however, risk is usually seen as volatility in an asset class in relation to other asset classes, say, equities to fixed deposits. So, greater the volatility, riskier is the security—that’s the common theme.
By that yardstick, though, equities would be the riskiest of all asset classes. Yet, study after study shows that equity is one of the best long-term means of wealth creation. Take for instance a recent Morgan Stanley report. It said that equity has delivered the best returns in India over 5-, 10-, 15- and 20-year periods, compared with gold, real estate and fixed deposits, among others. Over a 20-year period, equities returned 12.9%, gold 8.4%, bank fixed deposits 5.5% and property 6.2%.
Why, then, is there such a discrepancy in our perception of risk in equity as an asset class when it can offer some of the best returns?
The answer lies in understanding volatility. One of the common arguments of investors who do not want to invest in the stock market and seek alternative assets such as real estate is that short-term price movements can get too rough to handle.
Yes, that’s true. Equities are traded in the stock market daily, and millions of investors, including foreign and domestic institutions, not to mention the thousands of day-traders, generate such movement in stock markets. The sheer volumes coupled with the amount of fund flows create the turbulence and vast movement in stocks, sometimes daily. A huge institutional exit/entry can ruffle a stock price—and any investor, for that matter. That apart, fund flows into and out of the markets, too, have an impact.
By contrast, do investors in real estate look at ticker prices regularly? No, because there are none. Real estate prices do not jump up and down on a real-time basis and so cause no euphoria or anxiety in the hearts of these investors. Instead, house prices are determined by prices in and around a particular area; and not through a market-making institution such as an exchange, which provides prices on a real-time basis.
Contrast this again with cash in your locker. That too does not move daily; the cash value of ₹ 10,000 in your wallet holds steady. So, the volatility of cash in your wallet would be zero compared with volatility of real estate, which is, in turn, lower than that of stocks. But then, are these alternative assets good investments in the long run?
Warren Buffett explained the concept of volatility and risk in his 2014 annual letter to his shareholders. “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments—far riskier—than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk."
What we should understand is that volatility in stocks is not the same as risk. Instead, real risk is the loss of purchasing power—that the ₹ 10,000 in your wallet would be reduced to in the longer run. As Buffett says, holding cash is riskier than a stock portfolio built over time.
That brings us then to the key question of volatility—and why investors are so nervous about it? Sure, when prices rise, the tendency among many investors is to book profits, deepening the fall. And the little red marks in portfolios begin to cause anxiety.
However, to be a successful investor, it’s not so much about managing your portfolio as it is about managing your emotions. In other words, don’t look at the red marks. Instead focus on the lower prices of equities—and the opportunities presented to pick up equity assets as if on sale.
Volatility is an inherent characteristic of equities. But that does not imply risk as most people mistakenly think and as explained by Buffett. In fact, one can reduce the perceived risk in your portfolio by accumulating stocks at lower prices whenever volatility plays out in the markets. At lower prices, one adds more units of equity assets in an equity mutual fund for the same amount of money.
You might see a bit of red in a volatile market and your investment might lose some value, but you still own the asset, and you can grab some more of it during these times. Once the volatile periods are past, which sometimes could take a while longer, the value of your assets will again begin to rise. Remember, though, it is volatility that allows you to seize more equity assets on the go.
An easier way to benefit from volatility is to invest in mutual funds that are designed with intent to do this for you or simply invest through systematic investment plans.
Nimesh Shah is managing director and chief executive officer, ICICI Prudential Asset Management Co. Ltd.