In my earlier post on early retirement in India, I assumed an average return of 12 percent from investing in equity. A lot of people new to equity investing assumed that this 12 percent is a guaranteed rate of return like a fixed deposit which is not correct. You can find this misleading way of talking about equity returns even in popular personal finance publications.
In this post, I’ll help you visualise stock market return correctly so you can also understand the risks involved in equity investing.
Imaginary Fixed Deposit Returns Versus Stock Market returns
See below example that compares Rs 100 invested for 5 years in a 12 percent fixed deposit (FD) versus the stock market. I have used imaginary FD and equity return % to make a point.
The FD rate is guaranteed so your investment grows at 12 percent every year. But the stock market returns are not guaranteed and they go up and down but at the end of 5 years, Rs 100 invested in the stock market gives you the same ending value as the FD maturity amount in this imaginary example. So you can say that in this imaginary example the stock market gave you a 12 percent average return at the end of 5 years.
The 12 percent return I assumed in my early retirement blog post was based on a 20-year average of the Sensex from 1996-2016 and not the “year-over-year” return. Stock market returns go up and down sometimes wildly.
See below for the year-by-year returns of the Sensex from 1996 to 2016.
Hmmm… the market returns fluctuate every year. How to calculate returns?
Enter CAGR: Compound Annual Growth Rate. CAGR is nothing but the annual interest rate required for lumpsum ‘X’ to grow to lumpsum ‘Y’ over a period of ‘n’ years.
Since the stock market returns are volatile, a simple way to calculate returns is to take the starting year value and calculate what “FD interest rate” would have given the ending year value. So according to the above table Rs.1 lakh invested in 1996 would have returned Rs 8.63 lakh in 2016 which is an average return of 11.38 percent.
Don’t worry there are online CAGR calculators: http://www.moneychimp.com/calculator/discount_rate_calculator.htm
Will my equity corpus doubles every 6 years at 12 percent return as per Rule of 72:
The Rule of 72 is easy to apply when you get a steady 12% return every year like an FD.
But when you get non-straight line returns like the stock market, your corpus will not double exactly after 6 years @ 12 percent average return.
Look at the Sensex returns table above:
Rs 1 lakh invested in 1996.
Doubled to Rs 2 lakh in 2004 after 8 years.
Doubled to Rs 4 lakh in 2006 after just 2 years.
Doubled to Rs 8 lakh in 2014 after 8 years.
So Rs 1 lakh doubled 3 times after 18 years just as the Rule of 72 predicted for a 12 percent average return. If there are years when the markets are down then the doubling takes longer. That’s the main difference between the stock market and FD returns. You have to account for years when the market is down while investing in the stock market.
CAGR way of calculating returns % works only for lump sum investments. For a mutual fund, SIP returns you’ll need to use XIRR. If you look at your mutual fund portfolio statement, your mutual fund-house or MF aggregators like CAMS & KARVY report XIRR returns only.