How to get risk-free return in stock market

Lost your stomach for stocks in the past month? Each time the markets go down, we, the retail investors, panic. The good news changes to bad so fast that we can't wait to dump stocks that we bought the previous week at a multiple of 55, even if they are now at 24. Outlook Money has always advocated long-term investing as a mantra.

And a time when the market is volatile is best for testing this faith. And so we did. We ran a check on the behaviour of the main market index, the Bombay Stock Exchange's 30-stock Sensitive Index, or Sensex, to see how good or bad the markets could get if we just held on over the long term. The results? It has dropped our jaws!

The Sensex was a zero-risk investment if you held it for a period of at least 12 years. Buying the Sensex would mean holding shares of the 30 companies represented in it in the same proportion as the index.

Over 14 years, it returned as much as a fixed deposit; over 15 years, it did as well as the PPF. Remember, these were the minimum returns. You can do as well as 23 to 34 per cent per year between 12 to 15 years in the same market.

And over 20 years, the minimum and maximum returns converge to the mean Indian equity market return of about 17 per cent. That is an inflation plus (or real) return of over 10 per cent. Year on year. Without you having to lift a finger.  

To see the magic of this equity investing strategy, choose any day between 3 April 1979, when the Sensex made its debut at an opening value of 124.15, and 28 February 2007, when the market was at 12,938.09.

Now, notionally invest Rs 100,000. Suppose you were an unlucky investor and chose the scam-driven market peak of 23 April 1992 with the index at 4,467. Notionally sell after a year and get back just Rs 52,000.

Now choose any permutation of one year-that is, invest on ANY day of this 6,170-trading day period - and hold the investment for a year. Your returns would range between a loss of 54 per cent and a gain of 268 per cent.

That is, your Rs 100,000 could have fallen to Rs 45,594 if you bought on 26 April 1992, but had you made the same investment on 2 April 1991, you would have multiplied your money to Rs 368,000 for this was the pre- and post-Harshad Mehta scam period. What's the worst thing that could have happened to you? You could have lost half your money in one year. Best? You would have tripled your money.

But this boom or bust is precisely what we want to avoid. So, now hold the investment for another year. Choose any day and hold for a period of two years. Now the universe of minimum and maximum returns ranges from a loss of 26 per cent a year to a gain of 143 per cent a year.

The value of your Rs 100,000 would be between Rs 55,000 and Rs 590,000. Increase this holding period to five years and your return range becomes Rs 65,224 to Rs 911,000 over the worst and best five-year period. Increase it to ten years and you get a range of Rs 73,896 to Rs 20.47 lakh (Rs 2.05 million).

Now, the magic. Increase your holding period to 12 years. Choose any date in the past 28 years and hold the investment for the next 12 years, it does not matter that you invested just before the day in 1992 when the market dropped its bottom and shut down for four days.

If you hold your investment for 12 years, the Indian stockmarket shows NO downside risk. At the minimum, you get your money back. And in the best case scenario for this time period, you get a return of 34 per cent a year, that is, Rs 100,000 can become Rs 35 lakh (Rs 3.5 million) in this period.

At 12 years, you lose to inflation in the worst case scenario. So now, hold on for another two years. In 14 years, your minimum market return of 7 per cent gets inflation adjusted. At 15 years, you get the PPF returns and after that, the mean return of the Indian equity markets of 16-17 per cent. Markets the world over exhibit this trend, despite the caveat that past performance is no guarantee of future returns. In its Global Investment Returns Yearbook 2007, ABN Amro and the London Business School find that the world average across 17 countries for equities is a post-inflation or real return of 5.8 per cent, as against the bond real return of 1.6 per cent.

With mean global returns at these levels, is it still a surprise why foreign funds see it worth their while to flow into India? And why, for every uptick in the India rating, the fund flow gets stronger.

Why it works: textbook

To real world

What we did is probably no surprise to the finance academics, for we've used the principle of time diversification to reduce market risk and mean reversion to show that only average returns are possible from the index. But there is need to translate the textbook to the real world. The good news is that we find that the translation from theory to practice works wonderfully well in the time period and index example that we've chosen.

Time diversification is the term given to the concept that stocks are less risky in the long run as compared to the short, and if you hold the market index for long enough, you can reduce risk to negligible amounts.

In non-academic parlance, this translates into the maxim: time in the market is more important than timing the market. Therefore, in the short period of one year, the volatility is the highest, a range of 322 per cent. But the bounce between the minimum and maximum returns reduces as we extend the investing period.

Over five years, this return range falls to 64 per cent; in 10 years, to 38 per cent; to 8 per cent in 20 years; and 3 per cent in 25 years. Time takes the bounce out of the market. You get the average return if you invest in the index, over time.

The other academic principle we see experientially here is that of mean reversion: the tendency of the markets to give a mean return over the long term. Mean return is the average return across a time period taking into account the return each year and dividing by the number of years considered.

While the mean return is 22 per cent in the one-year rolling return period, the two-year mean return is 19 per cent. As much as 80 per cent of the mean return values are between 16 and 17 per cent in our study. So, over the long term, stock market returns tend to converge around the average return. This return for the Indian stockmarket is 16-17 per cent. Post inflation, this is a solid 10 per cent real return.

Index investing gives

Zero-risk returns

Tell this story to somebody who bought Arvind Mills at Rs 450 on 2 April 1992, at the height of the stock scam. The stock currently trades at Rs 50.55, a loss of about 90 per cent over 15 years. Such an investor will trash this research.

But then, this is precisely the story. We are not talking individual stocks here, the portfolio is diversified across time, after it has been diversified across stocks. Choosing different stocks belonging to different sectors, growth rates and market cap reduces overall portfolio risk.

And what better diversification to choose than the one provided by the market benchmark index that has a mix of sectors, sizes, profitability, dividend track record, growth, market cap and liquidity.

Holding an index over time ensures that you constantly hold only the winning companies since the losers get thrown out of the index. Remember Bombay Burmah and Crompton Greaves? These exited the Sensex in 1986.

Thirty-seven companies lost their place in the index. Some came back after they recovered their profits and growth, like Tata Power. The index is quick to reflect the fast growing sunrise sector companies - Bharti Televentures (now Airtel) was included in the index on 10 November 2003. If you bought the Sensex for Rs 10 lakh (Rs 1 million) on that date, your money will be Rs 15.88 lakh (Rs 1.59 million) today. A small part of this growth came because Airtel rose seven times during this time period.

How to hold the Index

An index fund used to be the industry standard for those who liked index investing. Founded by John Bogle, founder and retired CEO of the Vanguard Group of the US, index investing was quite the rage in a maturing US market that was disenchanted with the inconsistent performance of managed funds. Index investing took the stress out of stockmarket investing.

With lower costs than managed funds and similar sort of returns, these were the flavour of the decade. Typically, expense ratios of an index fund range from 0.15 per cent for US Large Company Indexes to 0.97 per cent for Emerging Market Indexes. The expense ratio of the average large-cap actively managed mutual fund is about 1.36 per cent.

Then came the upstarts, the exchange traded funds. Though these trade on a stock exchange like a stock, they are like index funds since they passively track an index and aim to mimic its returns.

But the quotes are real time and the cost is much lower - as low as 0.1 per cent (that is, 10 paise per Rs 100). India has just 17 index funds and five ETFs as compared to the hundreds in each category in mature markets. The reason is to be found in the stage of growth of the Indian market. There is money to be made in active management since the economy is yet to mature.

The alpha (a measure of performance of a financial instrument compared to the index) of diversified equity funds in India is 0.3 for the past three years. This means that diversified equity funds outperformed the benchmark index by 30 per cent on an average in the last three years. Investor preference for these returns and a relative lack of heavy marketing of the index and ETF products resulted in low investor awareness about them.

Our recommendation for Outlook Money readers who would like to take this zero stress, zero risk route to long-term growth is that they should choose broad market index ETFs over index funds.

The index funds in India remain plagued by a high tracking error (2.98 per cent for Sensex funds) and high costs (1.3 per cent). And costs matter. A difference of just one percentage point in fund management cost over 20 years will reduce returns to the tune of 18 per cent.

ETFs, on the other hand, cost just 40 to 60 paise each year on every Rs 100 corpus. A Rs 20-lakh portfolio will cost Rs 8,000 to maintain in an ETF, Rs 26,000 in an index fund and Rs 40,000 in a diversified equity fund per year.

What this means for you

In a line: there is money to be made in the markets. At the worst, you get your money back; at best, you get the average return for the market over the long term, though annual variations can be very wide.

This strategy works for you if you are a zero risk investor, who still wants the upside of growth that the stockmarket gives. But what if you want more? A slightly higher risk route would be to pick actively managed funds. Choose funds with good track records and consistent performance. For still higher return, and therefore risk, go the direct stock picking way.

We used the example of Airtel to show how its entry into the Sensex ensured that you got part of that growth. But what if you had bought Airtel shares on the same day with the same money? You would be worth Rs 75 lakh (Rs 7.5 million) today (instead of having Rs 15.88 lakh that the index would have returned)! And for the direct stock pickers, the growth in Indian entrepreneurship has just begun. If you can do it without losing your head, the market remains a great place to create long-term wealth.

ETFs work for you
	Returns (%)
Name	1 Year	2 Years	3 Years
Nifty BeES	13.3	29.9	24.8
UTI Sunder	15.2	30.1	26
Nifty	14	29.6	24.7
Prudential ICICI Spice	18.3	36.1	29.6
Sensex	17.3	35.2	28.8
Source: Mutualfundsindia.com Returns as on 7 Mar 2007

What they pay
Value of Rs 1 lakh invested in year zero
	Years	Sensex	PPF	5-year bank FD1
	5	3,57,718	1,57,424	1,36,354
	10	3,39,948	3,10,585	3,26,204
	15	3,78,934	5,47,357	6,81,402
	20	24,86,734	9,64,629	7,20,957
	25	55,11,853	7,68,676	15,07,242
Figures in Rs1Corpus rolled forward

Do's and Don'ts Do NOT invest if you can't be in for more than 12 years Don't try to beat the market Let indexing be the core of your portfolio Do not watch the daily market index value Do not get out when the index drops Do not invest large amounts at one go Invest a regular amount every month Raise this amount each year Switch your ETF, if its costs rise above 0.6 per cent Switch your ETF if tracking error rises above 2.88 per cent

The Methodology The daily closing values of the Sensex starting from the day of its inception, 3 April 1979, when it was 124.15, were used for this study. Values were taken across 6,170 trading days till 28 February 2007, when the index closed at 12,938.09. To remove period bias, that is, the error caused by choosing market entry and exit to suit any research conclusion, rolling returns over 1 to 25 years were used. That means the calculation was based on the return an investor would get if he bought the Sensex on any day in the 28-year time period and held it for a year. Or two years, or three ... all the way to 25 years. The data was worked on to account for the unequal number of trading days in different years. Then, for each of the above time periods, the daily return values were derived over the rolling return period in question. This was then annualised and the minimum and maximum values of the rolling return were then derived. The mean for each year was also calculated. A total of 81,159 data points were crunched to get the final trend line shown in the graph on the opening pages of this article.