What fund managers never tell you about stock market returns
- Fund managers leave out too many nuances and present a simplistic story that the human mind buys
Never underestimate a man who overestimates himself.”
— often attributed to Franklin D. Roosevelt
Most sales pitches tend to be simplistic and highly optimistic. The sales pitch made by many fund managers when they make a case for long-term investing in Indian stocks, directly or indirectly, is no different.
This is how the pitch goes. The BSE Sensex, India’s oldest and most popular stock market index, has given a return of 17-18% per year since inception. This is a fantastic rate of return. A return of 18% per year doubles an investment in four years and that’s why we should all buy stocks.
Rare is a fund manager who bothers to explain the math behind this pitch. But this is how it goes.
We are told that the BSE Sensex data starts from April 1979 when the Sensex was at a level of 100. It is important to clarify here that the Sensex was launched in 1986. Nonetheless, the Sensex levels are available from April 1979 onwards. As of Friday, the index closed at 58,803 points.
This implies a return of 15.8% per year. This means that if an investor had invested in the 30 stocks that made up the Sensex in April 1979, in the same proportion as the weightage that the stocks had in the index, she or he would have ended up with a return of 15.8% per year, if they had held on to their investment up until now.
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Of course, the assumption is that when a stock is dropped from the Sensex and a new one is added, the investor carries out a similar transaction in her or his portfolio. Another assumption that comes with this is that there is no cost to these portfolio changes.
Over and above this, a company also pays dividend on its stock. If the investor invests the dividends back into the Sensex stocks that would have meant a further return of 1-1.5% per year over the years. Adding this to a return of 15.8% per year, we are looking at a return of over 17% per year.
The math in this case didn’t quite work out as neatly as the fund managers talk. Let’s try again. This time, let’s take the Sensex level as of November 2014 when it had closed at 28,694 points. The per year return between April 1979 and November 2014, a period of more than 35 years, had stood at around 17.2% per year. Now, add a dividend yield of 1-1.5% on this and we are looking at a rate of return of more than 18% per year or money doubling in four years.
This was the original ‘invest in the stock market’ argument. Of course, the fund managers haven’t bothered to update their data. And further, if they had gotten into explaining the math, they would have lost their audience immediately and completely. Nobody likes to hear the details. Nobody likes to be told that this is how it is, but… All people want to know is what is in it for them. We are looking for certainties even in investing.
Trouble with averages
The devil, as always, is in the details. Let’s look.
1) It is commonly assumed that the Sensex level in April 1979 starts at 100. It doesn’t. As of 3 April 1979, the first day for which Sensex data is available, the level of the Sensex was 124.15 points. This might seem like nitpicking, but over a period of more than 43 years, it makes a substantial difference to the returns. As explained earlier, if we assume that the Sensex started at 100 points in April 1979, the return till date works out to 15.8% per year. But if we do the right calculation—assuming the Sensex started at 124.15 points—the rate of return per year falls to 15.2% per year.
Again, this might sound like nitpicking. So, let’s take an example to understand why it isn’t. ₹1,000 invested in Sensex stocks at 15.8% per year up until Friday would have amounted to ₹583,463. At 15.2%, it would have amounted to ₹465,562, which is around one-fifth lower. In the long-term, even a slightly lower rate of return tends to make a huge difference to the overall corpus an investor ends up with. Nonetheless, even at 15.2% per year, the gains are very good, if you are the kind who has managed to stay in the market for nearly four and a half decades.
2) The trouble with averages is that they hide much more than they reveal. Charles Wheelan explains this through an excellent example in his book Naked Statistics—Stripping the Dread from the Data: “Imagine that ten guys are sitting on bar stools in a middle-class drinking establishment in Seattle; each of these guys earns $35,000 a year, which makes the mean annual income for the group is $35,000. Bill Gates walks into the bar… Let’s assume for the sake of the example that Bill Gates has an annual income of $1 billion. When Bill sits down on the eleventh bar stool, the mean annual income for the bar patrons rises to about $91 million.”
While the average income of the people in the bar goes up, the individual incomes of the people sitting and drinking in the bar before Gates walked in, continues to remain the same. The point of this example is that an average is always sensitive to outliers. How does this apply in the context of the return generated by investing in stocks?
We have seen that between April 1979 and now, investing in stocks has given a return of 17% per year. Nonetheless, let’s divide the returns earned from investing in stocks that constitute the Sensex into two parts, before 1994 and after 1994. The BSE Sensex reached its then peak of 4,631 points on 12 September 1994. At this point of time, the annual return from 3 April 1979 to 12 September 1994 stood at 26.4% per year. Hence, the returns generated during this period outweigh the overall returns generated by investing in Indian stocks. It’s like Bill Gates walking into the bar and raising the per capita income of the entire bar.
So, what are the annual Sensex returns from 12 September 1994 up until now? The answer might just surprise you. It’s 9.5% per year. Sounds quite shocking. Even when we add the dividend yield, the returns barely manage to cross 10%.
There is another way to look at this. Between 1979 and 1994, in a little over a decade and a half, the value of the investment went up more than 36 times. Since then, in a period of nearly 28 years, the value of the investment has gone up less than 12 times.
Hard truths
In fact, we can do some more math to show that the returns on investing in the overall stock market have been front-loaded. Between 1979 and 1992, the Sensex peaked on 2 April 1992 at 4,388 points. This implied a return of 31.5% per year during that period. Since then, the return has been at 8.9% per year. Again, the investment went up by more than 34 times in the first 13 years of the Sensex and it has gone up a little over 12 times in the three decades since.
Understanding this is very important due to several reasons. First, fund managers are in the business of driving up investment for the investment firms they work for—the more money they manage, the more money they make. Hence, they are incentivized to sell you simplistic stories to drive up investment, not share the nuance of investing in stocks.
Second, very few people have been around investing in stocks since 1979. In fact, for a very long time, investing in stocks was something limited to a few large cities. Hence, how stocks have performed since 1992 or 1994 for that matter, are an important metric.
Third, timing is very important. If you had ended up investing in stocks when they were at their peak, as many retail investors tend to do, your returns would have been rather subdued. Let’s take another example to drive home the importance of this point. On 8 January 2008, the BSE Sensex reached its then peak of 20,873 points. The per year return between then and now has been 7.3%.
Fourth, at 17% per year over a period of three decades, an investment of ₹1,000 would have amounted to ₹111,065. At 9% it would have amounted to ₹13,268. And that’s a huge difference. This, again proves that if you are the kind who likes to invest a large amount in bulk, the timing of the investment is very important in the long-term.
The variations
Given these points, it is important to look at stock market returns data in the right way and not just randomly believe that stocks give a return of 17-18% per year.
As mentioned earlier, the Sensex data does not take into account the dividends given by companies. To make up for this deficiency, we look at the Nifty Total Returns Index which takes the dividends given by companies into account as well. The data for this index is available from 30 June 1999 onwards, a period of more than 23 years.
The returns of the Nifty Total Returns Index stand at 13.8% per year. Nonetheless, this is a point to point return calculation. Let’s also consider the per year return for a period of 15 years ending every August. The Nifty Total Returns Index data starts in 1999. Hence, the first 15-year period ended in August 2014. The second ended in August 2015 and so on. The average per year return, considering an investor held on to investing in stocks for a period of 15 years, has been 14.5%. This sounds pretty good.
Nonetheless, there is a huge variation here. For the 15-year period ending August 2022, the per year return stands at 11%. For the 15-year period ending August 2017, the per year return stood at 18.1%.
Again, this variance ends up making a huge difference in the amount of money you end up accumulating. ₹1,000 invested for 15 years at 18.1% per year amounts to ₹12,126. At 11%, it amounts to ₹4,765, which is nearly 61% or three-fifths lower.
So, when you invest in stocks and when you exit is of tremendous importance.
Now, let’s consider the per year return for a period of 10 years ending every August. The first 10-year period for the Nifty Total Returns Index ended in August 2009. The second in August 2010 and so on. The average per year return for anyone who holds to the investment in stocks for 10 years has been 14.2%. In this case, the variation is much larger. For the 10 year-period ended August 2020, the per year return stood at 9.1% and for the 10-year period ended August 2012 it had stood at 19.7%. Hence, ₹1,000 growing at 19.7% per year over 10 years would amount to ₹6,051. At 9.1% it would amount to ₹2,382.
Remember the cliché
What all this tells us is that there are no guarantees and the 17-18% return that is projected by fund managers often in their sales pitch, is just that—a sales pitch. There are too many nuances that they tend to leave out in order to present a simplistic story that the human mind buys.
Of course, this does not mean that there are no exceptions to this. There are fund managers who have given higher returns than 17-18% per year, over the years. But they are more an exception than the rule.
Also, this does not mean that you should not invest in stocks. The returns on stocks have been better than other forms of investing over the years. It’s just that, on the whole, they aren’t anywhere as much as fund managers like to project and they can vary quite a lot, even in the long-term. Given that, how much you end up with, depends on when you enter and exit the market, something that depends on the luck of the draw as well.
In this scenario, it makes sense to keep in mind the oldest cliché in investing of not putting all your eggs in one basket and diversifying and investing in other forms of investments as well.
Vivek Kaul is an economic commentator and a writer.
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