How risky is investing in the stock markets after all?


We all know that investing in the stock markets is risky - at least in the short term. But exactly how risky is it? And what does risk even mean?

Risk

There are several definitions of risk (Eg Volatility, Beta etc), some of them more academic than others.

We will use a more basic and intuitive definition - the risk of losing money.

So what are the chances of you losing money if you invest in the stock markets. And how can you minimize this risk?

It turns out that the single biggest factor that determines your chances of making or losing money in the stock market is the length of time you invest for.

For the analysis below, we took Sensex data from 1998 to 2016, and we looked at all consecutive 12-month periods for 1 year returns analysis (Eg Jan 1998 - Dec 1998; Feb 1998 - Jan 1999; Mar 1998 - Feb 1999 and so on), all consecutive 24-month periods for 2 years returns analysis and so forth. Instead of just taking calendar years, we take such continuously rolling time-periods in order to get a bigger and more representative sample of returns.

Investing for the short term (1-2 years)

The average annualized stock market returns historically have been about 14% per annum. But this average hides more than it reveals.

If you invest for just 1 year and look at your account at the end of the year, there is a 35% chance that you would have lost money.

How much loss are we talking about? The worst happened in 2008 and the loss was around 53%. But that's the worst. On average, the bad case is about a 7.5% loss.

Staying invested for 2 years instead of just 1 year decreases your chances of being in the red to 26% - lower but still significant. The worst case also improves to -23% annualized and the average 'bad' case is almost zero (-0.5%).

This is what we mean when we say that don't invest in equity for the short term, especially for your essential goals. Even though the average annualized returns are still 14%, but the chances of making a loss are also high.

Investing for the medium term (3-5 years)

As can be seen in the table below, 86% of all 3 and 4 year periods have had positive returns. So you would have lost money only 14% of the time if you stayed invested for 3-4 years. On average you would have made about 13% per annum, and the average 'bad' case is also positive now at about 2.8-3.8% - close to post-tax savings account returns.

Things further improve for a 5 year time horizon: 93% of all 5-year investment periods have had positive returns. The worst case is -7% annualized and the average 'bad' case is 5.4% - close to post tax FD returns for those in the highest tax bracket!

The average case for 5 year investments is our familiar 14% and the average good case (median of all good cases i.e. the 75-th % ile) is a whopping 20% annualized!

We can start allocating moderately to equities at these time horizons of 3-5 years.

Investing for the long term (6-7 years and above)

6-7 years or more is where investing primarily in equities is almost a no-brainer.

99% of all 6 year periods have given positive returns and so have all 7 year periods, with the worst case returns being a positive 2.6%.

For a 7 year time horizon, even the below average cases have given returns of 8.9% - more than an FD especially since these returns are tax free.

For 10 years even the worst case returns are 8%! Again better than FD returns since they are tax free.

The average returns are 15% per annum historically, and in favourable scenarios, returns of 18-20% have also been achieved.



 

Investment Period (years)

% Positive

Mean Returns (Annualized)

Worst Seen Returns (Annualized)

Bad Case Avg Returns (25th %ile Annualized)

Median Returns (50th %ile Annualized)

Good Case Avg Returns (75th %ile Annualized)

Best Seen Returns (Annualized)

1 year

65% of all 1 year periods have had positive returns

15.5%

-53.0%

-7.5%

12.1%

38.4%

92.6%

2 years

74% of all 2 year periods have had positive returns

14.4%

-23.2%

-0.5%

13.4%

28.1%

58.5%

3 years

86% of all 3 year periods have had positive returns

13.5%

-15.5%

2.8%

9.5%

22.6%

58.8%

4 years

86% of all 4 year periods have had positive returns

13.4%

-7.9%

3.8%

10.3%

19.1%

47.1%

5 years

93% of all 5 year periods have had positive returns

14.0%

-7.0%

5.4%

11.2%

20.3%

46.4%

6 years

99% of all 6 year periods have had positive returns

14.8%

-2.1%

7.5%

12.2%

21.3%

37.1%

7 years

100% of all 7 year periods have had positive returns

15.2%

2.6%

8.9%

14.9%

19.7%

29.0%

8 years

100% of all 8 year periods have had positive returns

15.2%

3.2%

10.6%

15.3%

19.1%

27.1%

9 years

100% of all 9 year periods have had positive returns

15.5%

5.6%

12.9%

15.4%

19.6%

24.4%

10 years

100% of all 10 year periods have had positive returns

15.4%

8.0%

13.6%

15.7%

17.9%

20.7%


*Using Sensex data from 1998-2016

Caveat

All the above analysis is based on how things have panned out in the past. The future can always be worse but as they say - history may not repeat but it sure does rhyme.

Check us out here and let us know what you think.