Insights

Why equity outperforms other asset classes

December 20, 2013 . Vidya Bala

Have you ever wondered why equity is universally acknowledged as an asset that delivers superior returns over other asset classes such as debt or gold in the long term?

The answer is a higher risk-reward ratio. Just take the case of your being a salary earner in a company vis-à-vis your running your own business. As a salary earner, while you may get steady payouts and periodic hikes, your upside is essentially capped even when your company does exceedingly well.

On the other hand, as an owner of a firm, you get to enjoy the full benefit of the profits arising from your company. Yes, you may share your profits with other partners; nevertheless there remains unlimited scope for you to gain more. On the flip side, in a downturn, you may also suffer the losses that arise from your business.

equity1

Own a piece of the company

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Now relate this to owning equities. By owning equity shares of a company, you simply hold part-ownership of a company and thus get a claim over its future earnings, to the extent of your holding.

While a part of such profits would be returned to you in the form of dividends, a good part of the profits is ‘retained and reinvested’ in the company. The price of a share captures your gains as well as the potential profits expected.

By assuming ownership therefore, you are the first-hand receiver of the company’s profits. But this is true when a company is going through a downturn as well.

Therefore, to take on higher risks, an equity investor expects to be compensated by way of higher returns. In other words, the higher return is the ‘premium’ you receive for taking on more risks than other asset classes.

The same is not true of an asset class like debt, where you may enjoy fixed returns but not gain because the bank/finance company is doing well or lending more to customers. Similarly, if you buy a property, the bulk of the profit is made by the developer; or at best a private equity investor; what you enjoy later is perhaps the residual capital appreciation.

With gold, yes, you may own it, but given that gold does not have any commercial usage to it, there is no imputed value that you can assign to it. Mere demand factors will drive prices, not backed by any sound business fundamentals.

No reinvestment risk

The other reason why equities manage to deliver more in the long term is that they do not exhibit the kind of reinvestment risk that asset classes like debt do. You may invest at 9% in a fixed income product and then on its maturity, realize that the prevailing rates have been reduced to say 7%.

With equities, you invest in the business prospects of a company and are, as such, not limited by such risk, as long as the company holds good prospects.

Also remember, investing in a share of company does not literally require you to run a company. There are experts – the management – to do the job for you; unlike running your own business. Hence, you actually get to enjoy the monetary benefits arising from being an entrepreneur, without fully assuming the role.

Look at your salaried job as your fixed income portfolio (not without risks though!) and an investment in equities as the asset that satisfies and adequately pays off your entrepreneurial spirits. Now that makes for a reasonably balanced portfolio!

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6 thoughts on “Why equity outperforms other asset classes

  1. Hello Vidya, Do you consider equities superior to real estate (plots of land in tier 2 cities – not built apartments/houses) in terms of returns? Theoretically, all the views expressed in your writing are relevant and insightful. However, from my personal experience, I have never been able to match the returns made by friends who invested in real estate. I am an avowed investor in equity mutual funds (all 5 star rated ones) , with no exposure to real estate, except my home. Of course, equity offers the advantage of investing small amounts on a regular basis. My question is, if equal amounts of lump sum investment were to be made in equity and real estate at the same time (assuming both are of excellent quality) , can we say with certainty that equities will deliver returns superior to real estate over a period of ten years and above? [This question has arisen out of curiosity, and hence, please be assured that I will not use it for making an investment decision]. Thank you

    1. hello sir, You proabably haven’t heard enough about people who lost money in real estate in legal tussles and fake sales 🙂

      In any case, the stakes in real estate, especially land can be quite high. Certainly land can make manifold returns when held and not every stock in the market will match that. But then the returns on real estate is so divergent across regions and properties that it is hard to say that they make money as an asset class. Just take a look at the NHB residex index and you will know how prices have actually languished in many cities.
      Besides, money in real estate is made by holding. People hold it for more than a decade or several decades and claim to have managed good returns. But when it comes to equities, nobody wants to look at more than 3 years.

      As for property, If you, say, buy a property now and let it in a prime location in the capital, then the rental yield is max 5% not more.It is much lower in the outskirts.
      If you look at capital appreciation, people look at absolute returns and forget the annualized returns (when comparing it with other asset classes). Just to give an example, you may say that somebody doubled their money in real estate in say 7-8 years. But if you take an equity fund that delivered 15% compounded annually, you would call it low.But the fact is the 15% annual return means doubling money in 5 years. Hence, in many cases, the returns are actually high but investors fail to see it.

      Also often times, the amount invested per se in real estate is so high that the moeny received on a sale gives a ‘wealth’ feeling. But investors do not invest high sums in equities. Hence, a Rs 10,000 doubling to 20,000 does not give you the same sense of having built wealth.

      I believe systematic investment over long time frames will help generate sufficient wealth with equities. While I am not stating that it is not possible in real estate, you need acumen and luck choosing the right parcel of land 🙂

      thanks
      thanks
      Vidya

      1. Dear Ms.Vidya,

        Your reply is highly convincing, and the examples you have cited are all relevant. My conviction for equities has risen manifold for which I must thank you. I am a staunch believer in equity. However, for quite some time now, my faith in equities was dwindling. Your reply has reinforced the power of equity, in my mind. Thanks a million for the reassurance.

        Srinivasan

  2. Merry X-Mas Vidya,
    pls advise :-
    a) What is the difference between FMP and Liquid Fund

    b) Can you get benefit of indexation in Liquid Fund , if you hold for more than 366 days.

    c) Do they both attract capital gains tax

    d) In the current scenario , for investment for more than 3 years , which fund should you recommend to me.

    1. Hello Arun

      Thank you. Wish you a fantastic year ahead!

      a. Liquid fund as the name suggests are liquid. they will invest in very short-term instruments and keep your money liquid so that you can remove anytime. FMPS have a fixed duration (so your money is locked in for that period) an your money will be paid back after that duration. they invest in debt instruments that have a maturity same as the fund. for instance a 1-year FMP will invest in instruments that have similar maturity. Tax treatment wise, both fall under debt category.

      b. yes, you can.

      c. Yes, liquid funds and FMPs attract tax like any other debt fund – your tax slab rate for less than 1 year and indexation after 1 year.

      d. Any of our long-term debt funds are suitable in our select funds list are suitable for 3 years and over. For specific fund advice, I would request you o use our ‘Ask Advisor’ feature stating your requirement. Our advisors will respond to your query. this will help us provide our services in a systematic way and track advisory queries better. thanks.

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