How much returns should you expect from Stock Markets?

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Let us start this article with one of the most basic questions โ€“ why is there a need for investment? Well, letโ€™s shout unanimously โ€“ RETURNS! The feeling of seeing those mouthwatering green color digits showing portfolio returns is just the next level! We can totally feel you ๐Ÿ˜Š

A portfolio comprises a mix of asset classes like equities, debt, gold, or even cryptos that have their own returns profile. Returns on each asset class are what drives each and everyone out there to invest their hard-earned savings.

But the question is how much should be the expectation of the minimum return from an asset class? 2%, 5%, 10%, 50%?

Is there any laid framework to decide on the broad expected minimum level of returns? Well, here we can help you with it.

The Framework

Well for beginners, there is a 3-point framework widely used to set the right expectations for returns:

Minimum expected returns are a function of 3 factors:

Real returns + Inflation + Risk premium = Minimum Expected Returns

Letโ€™s discuss them one by one.

  1. Real return: These are the returns from an asset class that you should get for deferring your current consumption i.e. returns that compensate you for delaying your current consumption.

Eg: if at present, you have Rs 1,000 to spend, you should get a certain % of return on this Rs 1,000 that will incentivize you to delay your current consumption and invest in that particular asset class.

So what is that return for you, identify that!

  1. Inflation: Inflation is that evil that eats up your returns silently. Just to give you a perspective – Rs 1 crore that you’ve just kept today in the bank will be less than 48 lakhs by the end of 15 years or even less, assuming an inflation rate of 5 percent. Thus, the expected return from an asset class should compensate you for inflation risk, i.e. compensation for the reduction of purchasing power of money.

Eg: currently in India, inflation is hovering around 6%-7%. Thus an asset class should generate a bare minimum of 6%-7% to compensate you for inflation risk. If the returns are less, then your actual purchasing power is decreasing.

  1. Risk premium: Investments are risky instruments and each asset class comes with its own set of risks. Broadly these risks can be divided into 3 types and an investor’s expectation of return should compensate you for these types of risks:

a.   Liquidity Risk: Risk of not being able to convert your investments quickly into cash without compromising on their value.

b. Maturity Risk: Risk dependent on the investment time horizon. Longer the time horizon, the higher the maturity risk

c.   Default Risk: Risk of the counterparty failing to honor a commitment. 

These risks will vary from one asset class to another. Like real estate investments have higher liquidity risk in comparison to equities. Long-term bonds have higher maturity risk as interest in the long term might impact returns. Credit risk bonds have a high default risk in comparison to other asset classes. Thus, return expectations for each asset class will vary depending on the type of risk it carries.

Thus minimum expected returns:

Real returns + Inflation + Risk premium = Minimum Expected Returns

Thus returns from an asset class should compensate you for the 3 factors discussed above.

Just to mention, the above framework is very broad and general, but itโ€™s definitely handy and can help you with setting the right expectations to start with.

To better understand this, let us take an example.

The Example

Akshay is 27 years old. He wishes to invest in certain long-term fixed income securities by way of mutual funds, to build his long-term portfolio. He can form his broad expectations using the above-given framework:

  • Inflation in the economy: 5%-6% 
  • Real returns he wants (over and above inflation): 1%-2%
  • Risk premium:
    • Liquidity risk: 1% (as mutual funds unit can be easily bought and sold)
    • Maturity risk: 1%-2% (as he expects a low to a moderate interest rate increase in the long term)
    • Default risk: 0.25%-0.5% (As its a fixed income investment)

Therefore, he expects to get returns anywhere between 9%-11% from his investments in long-term fixed-income investments.

Just to mention, the above framework is very broad and general, but itโ€™s definitely handy and can help you with setting the right expectations to start with.

Cheers!

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