ILLUSTRATION BY BINAY SINHA

FACT SHEET
EQUITY INDEX@ GOVERNMENT BOND INDEX@
Dow FTSE Dax Nikkei US UK Germany Japan
31/1/1990
Nominal 2591 2337 1823 37189 123 149 126 119
Real* 4408 4260 n/a 40474 209 272 n/a 129 $30.3 billion from US equity funds and
31/1/1995 $11.6 billion from European stock
Nominal 4244 3303 2235 20591 182 252 209 252 funds. All this has to be a cause for
Real 6117 4926 2764 20397 263 376 259 249 concern in asset allocation decisions
in G20 countries, including India.
31/1/2000 Turning to the performance of eq-
Nominal 13337 7641 8333 23819 256 425 223 319 uity markets in India, real stock mar-
Real 17125 9987 9669 23214 329 555 258 311 ket returns were positive in the last
31/1/2005 20 years. For instance, the real return
on the Nifty — assuming dividends were
Nominal 14118 6530 5726 15326 370 666 414 363 reinvested and the dividend yield was
Real 16042 7530 6199 15219 420 768 449 361 1.5 per cent per annum — was about 42
31/1/2010 per cent in the nine-year period from
Nominal 14959 7710 8334 15153 472 728 542 447 September 1991 to September 2000.
Similarly, the real return from September
Real 14959 7710 8334 15153 472 728 542 447 2000 to September 2010 was 129 per
@ Dividends are assumed to be reinvested and the average dividend yield on stocks is assumed to be 2% per annum.
Coupon payments on bonds are also assumed to be reinvested. cent. The Indian rupee 91-day Treasury
* "Real" prices are as of 2010. Source for underlying numbers: Barclays Capital bill yield was 6.14 per cent as of Sep-
tember 15, 2010. Assuming a Treasury
bill yield of this level for the last 10 years,
the equity risk premium in India from

STOCKS VERSUS
2000-2010 was about 4 per cent.
The standard advice to retail in-
vestors is to hold their portfolio of
stocks for at least five-ten years and
not try to be day traders. For older in-

BONDS
vestors, the preference could be to hold
more bank deposits choosing regular
interest income to future growth. In
practice, in 2008-09, Indian invest-
ments out of household savings in
financial assets were as follows. About
8.2 per cent of GDP was invested in
A balanced portfolio of stocks can give higher return compared deposits as compared to 0.4 per cent
in shares and debentures and 2.8 per
to short-term, risk-free benchmarks, says JAIMINI BHAGWATI cent in insurance funds. The 0.4 per
cent of GDP investment in shares and
sset managers worry about portfolio of stocks as compared to short- and Mike Staunton (referred to in the debentures was after the global down-

A the composition of their

investment portfolios, that
is, the proportions of
stocks, bonds and cash in
their holdings. This article is aimed at
sensitising retail investors in India about
the risks involved in investing in stocks
vis-à-vis fixed income securities.
Various empirical studies indi-
cate that returns from long-term in-
vestments in equity indices are high-
er than returns from risk-free gov-
ernment debt. However, over the last
100 years, there have been patches of
a decade or longer when diversified
equity portfolios have yielded lower
returns than Treasury bills/bonds. In-
dividual investors are tempted to make
equity investments after a period of
rising stock valuations and they get
burnt once markets inevitably correct
sharply downwards.
Asset managers draw the attention
of retail investors to the “equity risk
premium” in advising them to invest
in stocks over the long term. Howev-
er, the risks involved are usually not
explained. Equity risk premium is the
higher return, over an adequately long
investment period, which can be ex-
pected from investing in a balanced
term, risk-free benchmarks such as
Treasury bills (Treasury bonds carry
market risk, i.e. interest rate risk un-
less held to maturity). If stock mar-
ket returns were to be compared to sov-
ereign bonds, the equity risk premium
would be lower as government bond
yield curves are usually upward-slop-
ing, reflecting the liquidity premium
which has to be paid to issue longer
maturity fixed income securities.
The nominal and real returns in
the last 20 years on stocks and sov-
ereign bond indices (remaining ma-
turities one to 10 years) in the US, the
UK, Germany and Japan are shown
in the table. These four G7 coun-
tries were chosen since they are cur-
rently rated AAA.
Ithenwhile
the 10 years from 1990 to 2000,
equity markets in the US,
UK and Germany were up in re-
al terms, the Japanese stock market
was down by 63 per cent. In the last
10 years from 2000 to 2010, the stock
markets in all four countries have pro-
vided negative returns and have per-
formed poorly compared to sovereign
bonds. A London School of Business
study by Elroy Dimson, Paul Marsh
Economist of September 4, 2010 and
available at ssrn.com/abstract=891620)
uses a database of “long-run stock,
bond, bill, inflation and currency re-
turns to estimate the equity risk pre-
mium for 17 countries and a world in-
dex over a 106-year interval”. This
study finds that “taking US Treasury
bills as risk-free, the annualised risk
premium for the world index was
4.7 per cent”. Although different con-
clusions could be drawn on the size of
the equity risk premium, depending
on the country and the evaluation pe-
riod chosen, there have been peri-
ods when such a premium has per-
sisted compared to short maturity sov-
ereign Treasury bills.
In G7 countries, growth projections
and demographics point towards rel-
atively bleak prospects for equity mar-
kets over the next 10 years. Concur-
rently, US, German and Japanese sov-
ereign debt yields are likely to remain
at historic lows. The post-Second World
War baby-boomers will probably in-
vest less and consume more in their
twilight years. Perhaps some of this
pessimism is reflected in EPFR Glob-
al Data’s findings that in calendar year
2010, there have been net outflows of
turn and the average from 1994 to 2009
was around 1.6 per cent. (Source: RBI
Annual Reports.)
India’s growth prospects are bright,
its demographics are right and its stock
markets have risen sharply in the first
few days of this week. However, In-
dia’s financial markets cannot be
decoupled from G7 economies and In-
dian stocks are frothy in terms of price-
to-earnings (P/E) levels which are well
above 20. One of the reasons for the
financial sector meltdown in 2008 was
that regulators and macroeconomists
were not mindful of the extravagant
risks taken by financial intermediaries.
On the flip side, going forward Indian
capital market participants should be
careful to closely follow macroeco-
nomic developments, including the
risks associated with sovereign debt
rescheduling or even default among
developed countries with relatively
high credit ratings.
j.bhagwati@gmail.com
The author is India’s ambassador
to the European Union, Belgium
and Luxembourg. The views
expressed are personal