Why is equity the best asset class in the long term

Jun 20, 2019 / Dwaipayan Bose | 80 Downloaded | 4358 Viewed | |
Picture courtesy - UNSPLASH

Understanding risk / return characteristics of asset class is fundamental to investing. An asset class may have hundreds or thousands of different instruments or schemes, but all instruments in a particular asset class display similar characteristics. There are many asset classes but the four most common asset classes in the retail investor segment are:-

  • Fixed Income, which as the name suggests, pays fixed or floating rate of interest to investors till maturity of the instrument. Bank Fixed Deposits, Government small savings schemes, bonds, debentures, commercial paper, certificates of deposits etc. are examples of fixed income assets

  • Equity as an asset class includes stocks (usually listed), stock indices (e.g. Nifty, Sensex, Bank Nifty etc.) and derivatives which are instruments whose value is derived from underlying asset i.e. stocks and indices. Mutual funds which invest in equity or equity related securities are also part of equity asset class

  • Gold is a very popular asset class in India and in many parts of the world. Gold can be purchased either in physical form e.g. jewellery, bars, coins etc. or paper form e.g. gold ETFs, gold funds etc.

  • Real Estate is another popular asset class. Though for retail investors land and residential property are the most common real estate assets, other real estate assets include commercial real estates, Real Estate Investment Trust (REIT) etc.

How have different asset classes performed in the last 5 years?

The chart below shows CAGR returns of different types of assets belonging to different asset classes over the last 5 years. The first three asset types belong to fixed income asset class.


CAGR returns of different types of assets belonging to different asset classes

Source: Advisorkhoj Research


Please note that we have not shown real estate returns in this chart because there is no organized secondary market for real estate which makes reliable price discovery for research purposes very difficult. Readers who have bought or sold property or have followed the real estate market in the last 5 years know that the real estate sector is under severe stress for a long time. Many builders are on the verge of bankruptcy and the downstream effects of recession in real estate are now being felt in the NBFC housing finance sector. Ignoring real estate, you can see in the chart above that equity (as represented by Nifty) has been the best performing asset class. It outperformed both fixed income and gold by a wide margin.

Performance of asset classes over very long horizons

The chart below shows the growth of Rs 1 lakh investment in Nifty 50 over the last 20 years. Investment in Nifty over last 20 years would have multiplied 13 times creating substantial wealth for investors. The 20 year CAGR for Nifty 50 TRI was 13.5%.


Rs 1 lakh investment in Nifty 50 over the last 20 years

Source: Advisorkhoj Benchmark Returns


Let us now see how Gold performed over the last 20 years (please see the chart below). You can see that gold was much less volatile than equity. Rs 1 lakh investment in gold would have multiplied 8 times, giving a CAGR return of 11.2%. Very long term returns from gold are usually able to beat inflation, but they are well short of equity returns.


Gold performed over the last 20 years

Source: Advisorkhoj Benchmark Returns


If you compare the Nifty 20 year chart with Gold chart you will see that, Nifty was outperforming gold till 2008. Gold started outperforming Nifty in the wake of 2008 financial crisis because of risk aversion caused by the market crash resulting in investor’s flight to safety (gold is considered to be a safe asset). But gold price stagnated since 2013 – 14, while Nifty went through a secular up trend from 2014 to 2019. An inverse correlation has been observed between equity prices and gold globally, risk preference being the main driver. However, historical data shows that equity over long periods has outperformed gold.

Let us now see, how fixed deposits performed over the last 20 years (please see the chart below). If you invested Rs 1 Lakh in bank FD 20 years back and kept renewing every year, then your investment would have grown to Rs 4 Lakh. The CAGR return over the past 20 year period would be 7.3%. The chart below shows that fixed deposit is the least volatile (most stable investment), but the returns are also lower.


Fixed deposits performance over the last 20 years

Source: Advisorkhoj Benchmark Returns


The table below summarizes the 20 year returns of the three asset classes:-


Summarizes the 20 year returns of the three asset classes


Clearly equity is the best performing asset class in the long term.

Equity is volatile

One of the fundamental concepts in investing is the relationship between return and risk; they are directly related. While equity gave the highest returns in the last 20 years, it is also the most volatile asset class (compared to fixed income and gold). In the last 20 years, Nifty fell by more than 20% on 4 occasions, including one occasion (2008 financial crisis) when it fell by more than 50%. As such, investors perceive equity to be a risky asset. Despite the outperformance by equity over 20 years, RBI data shows that equity (including mutual funds) comprise a very small share of household savings in India.

While risk aversion is understandable (no one likes to make losses), investors should understand the difference between volatility and risk. While volatility refers to price fluctuations, risk is the possibility of making a loss. In our view, risk in any volatile asset is associated with the investment horizon. If your investment horizon is short, then equity can be very risky. On the other hand, if your investment horizon is long, then you give yourself sufficient time for prices to recover and make new highs as equity has always done. Despite four 20%+ corrections in the last 20 years, Nifty has almost always gone on to make a new peak (higher than the previous one) after each correction. Therefore, it is important that you have sufficiently high risk appetite and a long investment horizon for equity.

Beneficial tax treatment for equity

Equity (including equity and equity oriented mutual fund schemes) enjoy favourable tax treatments compared to most asset classes in India. Bank FD and many Government small savings scheme interest are taxable as per the income tax rate of the investor. If you are buying physical gold then you will be charged 3% GST on the value of gold and making charges of jewellery. Returns from gold (both physical and paper form) and debt mutual funds held for less than 36 months are taxed as per the income tax rate of the investor. Gold and debt mutual fund returns for investments held for more than 36 months are taxed at 20% after allowing for indexation benefits.

Returns from equity (including equity and equity oriented mutual fund schemes) investments held for less than 12 months are taxed at 15%. Returns from equity (including equity and equity oriented mutual fund schemes) investments held for more than 12 months are tax exempt up to a capital gain limit of Rs 1 Lakh in a financial year. Long term capital gains (investments held for more than a year) in excess of Rs 1 Lakh are taxed at 10%. Clearly equity is the most tax efficient asset class in India.

Conclusion

In this blog post we have discussed why equity is the best performing asset class in the long term.

  • Historical data analysis shows that equity has given the highest returns in the long term

  • Equity is a volatile asset class, but if you have a long investment horizon then you will be able recoup temporary losses and create wealth in the long term

  • Equity is the most tax efficient asset class

It is important to understand that equity mutual funds are subject to market risks. You should have moderately high to high risk appetite for investing in equity. If you are unsure about your risk capacity you should consult a financial advisor.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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