Opinion | Markets don’t help you create wealth. Responsible investing does
3 min read . Updated: 18 Mar 2019, 07:15 AM ISTKey to wealth creation via equities is to select a basket of high quality low risk stocks
What is more critical for successful long term wealth generation by investors—equity markets or investing style? Thinking about this question can help investors in prioritizing and making informed decisions in order to achieve their investment goals. Ultimately, investors need to understand what drives equity performance in the long term.
Economic growth is often seen as a key condition towards a successful equity market outcome. The reality, however, is different as starkly exhibited by the Chinese example. China has been the fastest growing economy in the world for the last 25 years. During this period, even as its economy grew by 12% annually, the stock market return was a mere 5% per annum. We have seen similar instances in Japan and Korea. In India, while it is true that over the very long term, high economic growth has gone hand in hand with high equity market returns (~11% equity returns versus 7.5% GDP growth between 1990 and 2018), there is little to no correlation between the two on a year on year basis.
Individual stock prices are broadly expected to move in tandem with the market. However, underlying stock specific factors play a large role and we see significant dispersion in stock returns over the long term. A startling observation is that globally the bulk of the wealth that has been created by stock market has been contributed by only 4% of the listed stocks even as the balance 96% struggled to beat money market returns. In the Indian markets, of the 613 companies listed in the last 20 years, only 87 companies (representing ~14% of the total 613 base) were able to deliver an annual return of over 25% over this period. The unmistakable theme hence is that stock selection plays a vital role in wealth creation. Consistency and quality of stock picking is of essence rather than just a passing requirement for success.
Ultimately generating wealth in equity markets is not about macro economy or about spreading allocations to the entire market, but about having a thought process to isolate the long term winners from the broader market.
This, of course, is easier said than done. What is the key to picking long term winners? Here we debunk another myth. It is said that in order to generate higher returns, you need to take on higher risk. In reality, it has actually been the opposite where the successful long term winners have delivered much lower risk than the market. As an example, over the last 10 years in the Indian market, a low volatility portfolio has handily outperformed the wider markets. This conclusion is based on the in-house research where the stocks were categorized into four equal buckets based on historical volatility, and the bucket which held the lowest-volatility stocks outperformed the others over the next 10 years.
So here, we have a partial answer to our quest—the key to creation of wealth through equities is to select a basket of high quality low risk stocks and invest in them in a disciplined manner. This is the role that investors should expect a responsible mutual fund to play for them. However, while stock selection determines the wealth that can be generated through equities, whether investors get to participate in it also depends on the investors maintaining responsible behaviour on their part.
Some common mistakes that investors make which impacts their portfolio returns are as follows: i) Over reacting to the market sentiment—the greed and fear cycle; ii) Focusing too much on the short term; iii) Delaying investment decision making.
As a result of the above gaps, investors have earned lower net returns compared to what equity funds have delivered. According to a study conducted by Dalbar, a global financial services market research firm based in the US, investors earned 5% lower returns annually relative to the returns generated by equity mutual funds over the last 15 years due to irrational investing behaviour. This effectively halved their cumulative wealth generation over this 15-year period. We have seen a similar leakage faced by investors in India as well.
A key spoke in the investing wheel is the financial adviser. The role of adviser is critical in educating and managing investor portfolios given the individual nature of an investors’ risk appetite. A responsible adviser plays a vital role in accomplishing an investor’s financial goals.
Thus, markets do not generate wealth, responsible investing does. And responsible investing needs to be maintained through the entire chain, including the fund manager, the adviser and most importantly the investor.
Chandresh Kumar Nigam, MD & CEO, Axis Mutual Fund