Most of the time when people look to invest in equity mutual funds, they ask what return should they expect. Unlike other popular investment options like PPF, fixed deposits etc, where investor has good idea about what return to expect, there is no guarantee for a particular level of return from equities. Lot of people talk about 15% to 20% return very casually. If anyone is promising a fixed level of equity return, you should stay away from that person. What we can do is to make an educated guess using various techniques.
Here, we try to address this very important question from multiple angles.
There are four main ways through which we can get a sense of what return to expect from equities-
- Equities should deliver returns in line with the growth in economy– Nominal GDP growth rate is used as a measure of growth in the economy. The idea is that top listed companies in the country, over medium to long-term, should at least grow in line with the country’s economic growth, if not more. Now there are companies in the index that are more exposed to global economy and hence can grow at different rates. But just as a simplification, we can say that broad group of companies will grow their revenue and profit in line with the economy. There could be some divergence periodically but in steady state the returns from equities should track the economic growth of the country. Historically, Indian economy has grown at a rate of around 13-15% in nominal terms. Going forward, India’s nominal growth is likely to be in the range of 10-12%. This is the return most equity investors should expect over medium to long-term.
Equity market return = Average nominal GDP growth rate (expected in the range 10–12%)
- Equity return as a function of risk free rate return and equity risk premium: Return from equities are often expressed in terms of equity risk premium. This simply means the excess return equities should deliver over the risk-free rate. Normally, 10-year government bond yield is used as a proxy for the risk-free rate. However, to simplify, we can also look at the return you get from a 10-year fixed deposit of frontline bank like SBI or HDFC. Historically, equity risk premium for Indian equity market has been in the range of 6%. The current fixed deposit rate is 6.9% (see here). As per this approach, if the fixed deposit rate is around 6.9%, equity return should be around 13%.
Equity market return = 10-year fixed deposit rate + equity risk premium
Equity market return = 6.9%+6% =12.9%~13%
- Using historical equity market return as a guide for future equity market return: In the below charts, we show the average returns for SIPs of different durations. Historically, 10-year SIPs have delivered a return of 14.6%. This is in line with above discussions. Going forward, we can be a bit more conservative in our return expectations.
Risk to above equity market return expectations
In the above discussion, we talked about average returns from equity markets and one is more likely to generate above returns if one were to invest systematically in SIP form. However, if one were to do a lump sum investment at any particular level, the valuation of equity market at the time of investment comes into picture. The current equity market valuation is slightly expensive and as a result, the future return could be below the average return discussed above.
In the below charts, we show subsequent five-year return for a give P/E band. The latest trailing P/E ratio is around 25x. Historically, if one invested at current valuation levels, the equity market has delivered single digit annualised return in subsequent five-year period.
To summarise the above discussion,, if one were to invest systematically through SIPs then it is possible to get annualised equity market return of 12-15%.
The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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