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The two pups in the picture are hard to distinguish, but this doesn’t hold true for equity and fixed deposit returns, those aren’t siblings or even cousins. And yet now that your large cap fund returns may look disappointing you are probably wondering why you didn’t allocate this amount to a fixed deposit or your PPF (Public Provident Fund) instead.

What if you are sitting on the fence and looking at long term equity returns to decide whether or not you should take the plunge? Five year returns in large cap schemes will also look disappointing at this stage; save a handful of schemes which are boasting double digit five year returns in the range of 10%-11%, others are all in mid to low single digits. Now you are really thinking, wouldn’t I be better off in a fixed deposit?

The answer is not a simple YES or NO, rather it lies in understanding what your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... objective is. What do you want your money to do for you?

What is equity and its purpose?

What is an equity investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains...?

Whether you invest in an equity fund or a stock, you are buying a portion of a running business.

How does this investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... benefit you? The expectation is that the business will continue to grow and generate profits.

As a running concern, there is potential in future growth of earnings and profitability, this potential is reflected in stock prices.

In simple terms, an upward trending stock price represents a positive future expectation from earnings and vice versa.

However, do you think that business profitability grows overnight? Unlikely. Do you think that its growth is always a defined straight line? Not really, there are cost pressures and revenue pressures from time to time. This also gets reflected in the stock price which, can move up and down in the many years it takes for business profitability to keep growing. You will agree that businesses become large with stable profitability over many years. Even then to maintain the profitability at a high level of growth requires continued effort and investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains....

So, if you are an investor who has bought into this business (through stocks and funds), however small or big your share who have to stick it out in this ride with the company to reap the benefit of earnings growth over the years.

Now – what complicates this journey for a stock investor is that stock prices also get impacted daily thanks to macro factors that impact trades in listed shares.

Hence, not only are you in a long journey for profit growth, but also, in the interim you have to deal with impact of external factors which make the price move up and down.

If you have ever been in a fitness regimen, think about volatility in stock pries as disturbances to your daily routine. While most days you get to do your routine as desired, some days you may have to go into work early, or your kid is unwell or you had a late nightery and just couldn’t make it to your work out or perhaps you are on vacation. There are disturbances but they don’t take away from the long-term benefits of a good and regular fitness regimen. Moreover, you have to remain disciplined over long periods of time to reap benefits.

Equity investing too requires – discipline, ignoring short term volatility and understanding that wealth creation will never be linear, it requires time.

Comparing equity with FDs just doesn’t make sense

Now let’s come to this comparison of fixed deposit and PPF returns with equity. I strongly believe that it is misleading to do so. Something like apples and oranges. Here’s the thing, as mentioned above equity returns take time to come through and are never linear.

So, if in one year your return from equity investments is negative or below your expectation do not worry. In the next year or year after or year after that returns can be much more than expected and make up for the bad years.

Now what if the five-year compounded return on equity is below your expectation or negative? Had you invested in the BSE Sensex or any large cap equity fund in January 2008, your returns in January 2013 – five years later would be just about break even or negative. In these five years, you pretty much didn’t make anything. What then?

Well then you know the returns are not far – wait for another 6-18 or 24 months and things look very different. In the case above, by the beginning of 2014 equity markets were touching new highs and by Jan 2015 double digit annualised returns from equity investments held for 5-7 years were back.

Equity investments are a game of patience. It doesn’t matter if the 3 or 5 year return today is below fixed deposit interest or PPF, what really matters is the quality of your equity investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains.... When the cycle turns, good quality stocks and funds recover fast and gains accumulate in chunks.

If you get scared of this volatility and don’t invest in equity or redeem when your five-year return is close to zero, then you would have made good your losses, with little chance of benefiting from gains in an upward cycle that follows.

Equity returns can be abnormally low and extraordinarily high in shorter periods. You could lose 30% of your fund/stock value in a month or gain 100% in a year. Key is to remain invested.

Do you agree that one should not compare fixed deposit and equity returns? Let me know your thoughts in the comment section.

How should you play equity?

Firstly, don’t be in a hurry to book profits. You can change the stock or the fund you are invested in but remain in the asset class. For how long? Historical data on Indian equity market benchmark Sensex and Nifty 50 shows that – 7 is the magic number. If you are invested in the index for seven years the chances of a negative return are very low.

If you remain invested for 10 years, you have an 80% chance of making at least 10% annualised return.

Hence, for equity your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... horizon should always be above 7 years. See this story for more detail.

Source: Internal Research

Secondly, keep investing regularly. Unless you do this, you will not be able to invest close to the bottom of a market cycle and unless you are able to invest at least some amount in the downward cycle, you will not make those extraordinary gains in equity.

When you are closer to your goal or the reason you were investing in equity, transfer the amount to a stable return security like fixed deposit or debt mutual funds. Ideally, do this at least 2 years before your goal. This will lock in any gains you have already made and if you haven’t made the gains you sought, you still have two years of stable returns to benefit from.

The truth is that equity risk is worth it only if you remain invested. If you get a chunky return say in the firsts 3 years of your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... then you must book some gains and transfer them to a stable return security. Otherwise, keep at it slow and steady.

And remember, there is really no point comparing equity returns with fixed deposits for one, three or ten years. Both serve a different purpose.