Sunday, March 19, 2006

Are stock markets returns for real?

Authored by Sameer Nair
This is the story of two childhood friends Anju and Manju. Anju was a quant. wizard while Manju was the English literature/History kind of girl. Anju slogged her way to a premier engineering college and then realized that she was more interested in finance. She cracked the CAT and in two years she landed a job in a bank.

Meanwhile Manju had five years of pure fun at Xaviers before starting work at an Ad agency. They met at the school alumni meet in 2001. Manju thought it fit to ask Anju for some tips on investments. Manju had invested all 4 lakhs of her savings in a bank FD at 7 %. Anju was flabbergasted. She wanted to be of help to Manju. “You see given that inflation is at 4 % you are in effect only getting a Real rate of return of 3 %”.
Manju didn’t understand a word but felt too ashamed to ask the meaning of that statement. Anju went on to explain how she had invested a similar sum in the stock market. She expected it be the surest method to beat inflation. In a few years she expected to grow her investments enough to move from her tiny one-bedroom apartment to a larger flat in the same locality. Manju had a more modest goal of upgrading from her Maruti 800 to an Esteem in a few years. At six lakhs she felt it was beyond her.

Cut to 2006. One more reunion. Anju’s stocks had performed brilliantly. She earned a “CAGR” of 24% she told Manju. As usual Manju didn’t understand a word. “So you must have moved into that large flat right” Asked Manju.

“Alas, real estate rates have gone through the roof, that flat is still unaffordable” Anju Said.

Slowly Manju started understanding what “real” returns meant. Car prices had crashed. An affordable bank loan coupled with Bank FD had allowed her buy a Honda City. In real terms she had performed better than Anju who could yet not buy her dream house.

Anju went home feeling jealous. Everything had gone well for her. Seemingly. Yet Manju the financial dud had done much better for herself. Over the next few days she thought of only this and nothing else. To the point where it got unbearable. She decided that she had to go back and speak to her B-School Prof. to figure out what went wrong.
Anju called up Professor Tsunami-nathan to find out more about the “Real Returns” conundrum.

Professor Tsunami-nathan intoned, “While inflation of consumer items like foodgrains, clothes and other items of everyday use has been moderate, capital assets like real estate equity and gold have risen in value substantially.”

“Under such circumstances, is it not silly to hold on to the Real Returns = Nominal Rates minus Consumer price Inflation formula? Especially when consumer price inflation rate does not reflect the huge increase in capital asset price.” asked Anju.

“Its as silly as the statistician who drowned in a river whose average depth was only 4 feet. He believed that being 6 feet tall, he would have no problem crossing the river, till he reached the point where the river was actually 12 feet deep” replied tsunami, with a grin that did not hide his contempt for Anju

“The inflation rate is merely an average. The average, as you are aware can conceal huge variances in the rise in prices of individual components” Tsunami went on.

He never had patience for the student who applied formulae without understanding the underlying assumptions. As corollary, he did not really enjoy discussions with his students, supposedly the intellectual cream of India

“To believe that booming stock markets have made investors as wealthy as these pink papers make us believe is absurd. A person’s wealth increases when he can buy more with what his investments generate for him. In fact the next time the stock market falls by 20%, you may actually become wealthier,” he said.

And Anju being the quick learner was quite clear. “If that flat that I want falls in value by 50% and my stock investments only by 20%, I may in fact be able to buy it.”

She went home and prayed that her dream house becomes affordable. Unlike earlier, when she prayed that her stock investments rise in value. She did not care for the nominal value of her shares any more, she was only interested in what they helped her purchase.


kuffir said...

this is offtopic, but i'm curious : are you related to nyayapati raghava rao?

Nyayapati Gautam said...

Yes, I am.

S said...

Sorry but the point of the tale is not clear to me. Different assets grow at different rates. That is known to everybody. If your investments have made you 20% that is superior to a FD which gives you, say, 10%.
The fact that some other asset, (eg housing) has grown at 30% does not detract from the 20% you got. How you measure inflation doesnt matter. Inflation is common to both FDs and stock market returns.

In fact i didnt get your post at all. sorry maybe i am being especially dense today. its been sometime since i have had a beer.

politically_incorrect_guy said...

Excellent piece of article... cannot but wholly agree with the PROFESSOR. Appreciation in the value of shares held or appreciation in the value of that house or flat that you buy and live has zero real value, unless you cash it... and those who talk of high CAGR and inflation beating returns in stocks would be the ones who will talk about "Stock markets being evil" kind of things, when the markets go down ... it happened in past 1993, then 2001 and will happen again and again.

Even worse is how some people feel happy and feel to be extremely rich, when their house or flat they live (and bought long ago) has doubled or tripled in value. It is meaningless, because you are living in that house and u cant sleep in a local park or street?

vishnuvyas said...

Being a statistician by profession (offlate), one thing that first learns is that averages are just one aspect of any distribution, the second factor you look at is variance (or standard deviation). So any one who cracked the CAT to get to a B-school should have known that.

The second thing, as a previous commenter mentioned is that a stock that grows by 20% pa is still way better compared to a FD that grows by 10% pa. And being in stocks liquidity is also higher which can be considered as some form of extra value (i guess its called amortisation). And hence a good stock market would actually increase your wealth.

Reagarding inflation, CPI is only an average and sector based inflationary ones are always available. So for anju, since capital assets inflated, her dingy 1-bed room flat did make her wealthy (by 30% of what it was worth during their first re-union) and a strong stock market + a good housing loan should have almost without doubt put that 3 bedroom flat in her reach.

And as far as manju who ended up with a honda city did not end up as wealthier as she is potrayed. (as it is common with consumer products in general, and cars in particular, there is always a trend in depreciation).

So, in the end anju did end up with a good bargain afterall.

(Or I have missed your point completely!)

Anonymous said...

Hi Vishnu,

In a sense by acknowledging that sector based inflationary rates are available are you not concurring with the author.

The author is saying that one single rate of inflation used to measure real returns can be misleading.

For instance, for two families whose consumption baskets are different it is possible that inflation rates for their respective baskets are quite different.

Would not their purchasing power be impacted differently by inflation.

In an economic cycle where CPI has been moderate but asset price inflation has been significant, how relevant is it to use CPI to compute real rates of return.

Which one is more likely

1)You invest in stocks by cutting down on current consumption of food articles so that you can consume them later

2)You invest in stocks out of an investible surplus with a target to move into a larger house, buy a bigger car.

If you have invested with the latter in mind a rise in real estate has somewhat blunted your ability to buy that large house. Is is right to calculate real rates of return using the same Inflation rate, or as you have suggested should one use sector specific inflation rates.

Anonymous said...

Hi, I did not entirely get the point of your post. To start with, I appreciate the fact that the inflation rate is an average of many components. However, in this case, I do not agree with your view that Anju is worse off than Manju because she could not buy her dream house while Manju could upgrade to a better car. The fact remains that given the superior returns earned by Anju in the equity market, she would be in a position ceteris paribus to buy more units of a common consumption basket as compared to Manju. It just so happens that the point of reference has been distorted here by the differing target purchases. The arguement would hold only if both were planning to buy the same asset.

S said...

The previous poster has got it right. Unless one is talking about a utility function. But that varies from person to person and comparing utilities across individuals leads nowhere. (Indeed i think the utility of getting some utility needs to be measured. A second derivative if you will!)
The author is stangely quiet.

Nyayapati Gautam said...

Hello S,

I think the fact that in effect two variables

1) Intended consumption
2) Investment pattern

were both different for Anju and Manju has created confusion.

let me explain my point -

1)The effort to measure "real" interest rates is an acknowledgement that rise in prices brings down effective returns

2)The solution is to adjust for the inflation by subtracting it from the nominal returns

3) The question then is what happens if the consumption basket for two families is very different from the basket used to compute the rate of inflation published by the govt.

Lets for example assume that much of the inflation is caused by rise in wheat prices in a specific year. What if my family is not a consumer. Lets say there is this other family which consumes much more than the standard basket.

Assuming that they have invested in the same bond would family one not feel that their interest income has not in real terms been what the Govt has claimed?

If i understand your point about utilities and the common conumption basket argument by the earlier comment, you are saying that in effect real rates of return cannot be measured unless the consumption basket is common.

Which is precisely my point!!

Hence the silence