Why Lower Returns May Not be a Bad Thing?
Inflation has
remained at a subdued level for the past 3 to 4 years. From average levels of
over 6% historically, the CPI has averaged around 3.5% over the last 3 years. What
does this mean for investors?
Meanwhile, returns
on an average from both debt and equity asset classes have also fallen in
recent times. Is this necessarily a bad news?
Real Returns – The
Right Barometer
For investors,
what really matters is the Real Returns, which is nothing but the excess of
actual returns over and above the inflation levels. For instance, a 10% p.a.
return during times when inflation is 8% is not as attractive as a 7% p.a.
return when the inflation is 3%. This is because, the real returns in the
latter case is 4% Vs 2% in the former.
The fact that
inflation erodes purchasing power is known to us all. It is also important to
appreciate that during the benign inflationary periods, it is necessary to
lower expectation of investment returns. The first and foremost requirement of
an investor, in any asset class, is to beat inflation. An investment that is
expected to yield lower than inflation is not a worthwhile one.
The expected
return of an equity investor is composed of two important factors – equity risk
premium and inflation. Therefore, the returns an investor earns should be more
than the inflation in the economy, i.e., the return on a real basis (nominal
return minus inflation) should be positive.
Why lower equity returns is not necessarily a bad news?
In the last 3 to 4
decades, the Indian equity markets have delivered returns of around 15% p.a. It
is interesting to note that India’s nominal GDP growth during this period has
also been around that level on an average. This relationship is not merely a
mysterious coincidence, but a strong linkage that could prevail over the next
decades to come.
Nominal GDP = Real
GDP + Inflation
Nominal GDP being
the summation of Real GDP and inflation, a lower inflation would bring down
Nominal GDP, keeping the Real GDP constant. The key lesson from this linkage is
that with nominal GDP growth expected to be lower than what it was during the
last few decades, means we need to lower our expected returns from equity
markets, in order to avoid disappointment. But this is no bad news as our real
returns may not be impacted assuming the real GDP growth stays intact over the
long term.
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Sources:
Various publications
Disclaimer: The
information provided herein is based on publicly available information and
other sources believed to be reliable, but involve uncertainties that could
cause actual events to differ materially from those expressed or implied in
such statements. The document is given for general and information purpose and
is neither an investment advice nor an offer to sell nor a solicitation. While
due care has been exercised while preparing this document, we do not warrant
the completeness or accuracy of the information. We will not accept any
liability arising from the use of this material. The recipient of this material
should rely on their investigations and take their own professional advice.
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