Invest 100% in stocks? Be aware of the bull market’s investing myths

“What’s up?” she asked Vivaan as soon as she entered the bedroom. He was lying down curled up like a baby.

“Oh, you have come back early,” said Vivaan, who was a mid-level engineer in a software company. “I didn’t hear the door open.”

“Well, if you blast music at such a high volume, there is no chance of hearing the door open,” replied Mairaa, who had just finished her PhD and gone back to working for a company in the business of supposedly managing other people’s money (OPM).

“That’s true.”

“So, tell me what’s bugging you?”

“Well, I just saw this reel of a financial influencer.”

“And?”

“He said that anyone investing in the public provident fund (PPF) is making a huge mistake because investing in stocks gives higher returns.”

“And?”

“I have been investing regularly in the PPF, and now, I feel stupid.”

“Why?”

“PPF gives a return of only 7.1% per year. I could have made much more by investing that money in stocks or even in equity mutual funds (MFs) for that matter.”

“Hmmm.”

“You have nothing to say on this?” asked Vivaan.

“I do,” replied Mairaa. “But I have got this new coffee brand. Why don’t you first make a cup for both of us and then we can talk.”

“Sure.”

“And add a dash of soy milk to it,” said Mairaa, as Vivaan left the bedroom. “I was told it really elevates the taste.”

True uncertainty

Vivaan arrived ten minutes later with two cups of freshly made coffee. “That’s what I really needed,” said Mairaa, taking a sip and feeling refreshed .

“Okay, now tell me,” said Vivaan.

“See, you understand what uncertainty means?”

“You mean investing in stocks is risky?” he asked.

“It’s a little more than just that.”

“Okay.”

“There was this American economist called Frank Knight, who lived through the 20th century. He is famous for having defined the difference between risk and uncertainty.”

“Ah, I love jargon.”

“It’s not jargon,” replied Mairaa. “When financial influencers say that investing in stocks and MFs is better than investing in PPF, they do not take true uncertainty into account.”

“True uncertainty?”

“Knight basically said that there are two kinds of uncertainties—one is measurable and the second one isn’t. He termed measurable uncertainty as risk and the unmeasurable one as true uncertainty.”

“Now, this is getting interesting.”

“When you toss a coin, you know that it will either come out as a head or a tail. So, there is a 50% chance of getting either. In this case, uncertainty is measurable and that’s the risk.”

“Makes sense.”

“The same is true when you throw a dice labelled one to six. Each number has a one-sixth chance of landing up.”

“Yes.”

“But that’s not true about the stock market. The future of any stock market is truly uncertain.”

“That’s not true,” interrupted Vivaan. “I know for a fact that over the years returns of investing in stocks have been higher than that of investing in PPF.”

“Do you?” asked Mairaa.

“Yes. In fact, the NSE 500 index, which is a very good representation of the broader stock market, has data starting from 1 January 1995, a period of close to 30 years. The index has given a return of around 11.3% per year. If you add a dividend yield of another 1%, it implies a return of higher than 12% per year, which is very good.”

“Of course, it is good,” said Mairaa. “But it doesn’t take two things into account.”

“What two things?”

“First, you have no idea how high returns were on PPF in the past.”

“Oh.”

“Through the 1990s, the return on PPF was 12% per year. Since then, it was largely 8-9% per year up until March 2020.”

“Hmmm. I had no idea.”

“You clearly didn’t,” said Mairaa. “Also, this is not the important point.”

“Then?”

“The rate of return on PPF at any point of time was fixed. You knew that you were going to earn that. There is no true uncertainty in this case.”

“Hmmm.”

“Whereas investing in stocks is all about understanding true uncertainty. As Justyn Walsh writes in Investing with Keynes: How the World’s Greatest Economist Overturned Conventional Wisdom and Made a Fortune on the Stock Market: “Uncertainty, in respect of stocks, may be attributable to ambiguity about the business prospects of a particular company, more generalized misgivings about the state of the stock market or the broader economy, or some combination of these factors.””

“What does this mean in simple English Mairaa?” asked Vivaan.

“It means that the 11-12% per year return you were talking about are average returns over the last three decades and there have been extended periods in between where returns haven’t been anywhere as good.”

“Really?”

PPF’s case

“Yes. Let’s take the BSE Sensex. It reached its then peak of 4,631 points around mid-September 1994, and didn’t deliver any returns over the next nine years.”

“Oh, but that’s the 1990s you are talking about,” replied Vivaan. “Everything was down in the 1990s. Have you heard all those slow songs from the decade, the kind they play in autos and cabs?”

“Yes, I have,” said Mairaa. “And I love them. I can listen to Kumar Sanu all day.”

“Kumar who?”

“Never mind. Let’s say he was the Diljit Dosanjh of his era. Or maybe Arijit Singh.”

“Why talk about the 1990s, when we are in the 2020s.”

“Let me give you more recent data. The BSE Sensex reached its then peak of 20,873 points on 8 January 2008. What kind of returns did it deliver over the next decade?”

“Must have been very good.”

“Well, you will be surprised to know that it gave a return of 5% per year during the period. You would have made almost the same kind of after-tax returns by investing in fixed deposits, and with no true uncertainty to boot. PPF would have delivered higher returns than stocks.”

“Oh, but you are talking about just the Sensex, which is made up of only 30 big stocks. Why not talk about the broader return of the stock market?”

“Well, the NSE 500 did slightly better during that period and delivered a return of 5.8% per year.”

“Oh.”

“Yes. So, the point is that investing in stocks, directly or indirectly, is important, but even in the long-term, of close to a decade, returns can be quite ordinary. Which is why it is important to have your investments spread out across and within different kinds of investment assets. The future of the stock market is truly uncertain, irrespective of whatever finfluencers and those in the business of managing OPM might say on the basis of recent performance,” explained Mairaa.

“Hmmm.”

Sleight of hand

“Also, did you see that reel where a stock market old-timer turned finfluencer takes an example of earning 26% per year return from investing in stocks?” asked Mairaa.

“Oh, I did. Though he did build in his ifs and buts,” replied Vivaan.

“Which he did,” said Mairaa. “But in times like the current one, who is listening to the ifs and buts and maybes.”

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“True that.”

“Basically, many finfluencers end up highlighting the recent performance of the stock market and build a case for 100% investment in stocks. On 23 March 2020, the NSE 500 index was at 6,243 points. By 16 September 2024, it had reached 23,968 points. This works out to a return of 35% per year.”

“Wow.”

“Yes. But there is a sleight of hand in this calculation. What I did not tell you is that from the end of February 2020 to 23 March 2020, a period of a little over three weeks, the NSE 500 fell by a third or 32.4% to be exact, once the world started to recognize the real dangers of the pandemic. If you calculate the returns from the end of February 2020 to 16 September 2024, it works out to 23.3% per year, which is also pretty good, but nowhere as good as 35% per year.”

“Interesting.”

“The finfluencers have been projecting these recent returns into the future in the content they are putting out there. So, have many retail investors in their clamor to invest in initial public offerings (IPOs) of companies.”

“Yes.”

Regression to the mean

But there is something that most investors don’t seem to be taking into account.”

“Which is?”

“Reversion or regression to the mean.”

“What’s that?” asked Vivaan.

“As Daniel Kahneman, Olivier Sibony and Cass Sunstein write in Noise—A Flaw in Human Judgement: “Extreme observations in one direction or the other will tend to become less extreme, simply because past performance is not perfectly correlated with future performance. This tendency is called regression to the mean,”” explained Mairaa, quickly pulling out the book from her bag and reading from it.

“Can you please explain this in the context of stocks?”

“From January 1995 to around mid-August 2003, the NSE 500 barely gave any return. This reversed from around mid-August 2003 to early January 2008, when the NSE 500 gave a return of a little over 47% per year. Then things were subdued for the next decade with the NSE 500 delivering a return of around 5.8% per year. And things have looked up again since March 2020.”

“Ah, a very interesting cycle.”

“Indeed. In fact, as Robert Shiller writes in Irrational Exuberance: “There is a sort of regression to the mean for stock prices: what goes up a lot tends to come back down, and what goes down a lot tends to come back up,”” said Mairaa, getting hold of another book from the almirah.

The umbrella

“So, are you predicting that stock prices will fall?” asked Vivaan.

“Well, you have clearly forgotten what I said about true uncertainty,” replied Mairaa.

“You have totally confused me now.”

“Typically, in the past, stock prices have regressed to the mean. So, something like this may happen, but at the same time one doesn’t really know for sure. Also, even though cycles repeat themselves, one doesn’t know when.”

“So?”

“So, investing in PPF and bank fixed deposits is as important as investing in stocks. It’s important to maintain a sense of balance and be prepared.”

In the past, stock prices have regressed to the mean. At the same time, one doesn’t really know for sure. Even though cycles repeat themselves, one doesn’t know when.

“Hmmm.”

“It’s like buying an umbrella and being prepared for rain. Of course, if it doesn’t rain, one ends up paying for the umbrella and has to carry it around everywhere, which can be a pain, especially given your tendency to forget umbrellas in cabs. So, there is a cost to that preparation; but going to buy an umbrella once it has started raining means you are going to get wet.”

“Yes.”

“If you invest some of your money in PPF, you will end up not investing that in stocks. If stock prices continue to go up, you will feel having missed out on those returns.”

“Yes.”

“But if stock prices stagnate or they fall, then you will be happy about having invested in PPF, because it will ensure that the value of your investment portfolio doesn’t fall at the same pace as it would have if all your money had been invested in stocks.”

“Yes.”

“Basically, you can’t start preparing for an unstable environment after it becomes unstable. You have to prepare for it when it is stable,” explained Mairaa.

“Yes. And you know what all this tells me?” asked Vivaan.

“What?”

“Well, we haven’t had a fight for a long-time. When will regression to that mean happen?”

(The example is hypothetical)

Vivek Kaul is the author of Bad Money.