The year 2018 was a volatile one for equity markets, which is an ideal situation to study the effect on equity funds as there was no steep rise of fall through the year.
Mutual fund (MF) investments, especially in equity MFs, are subject to market risks, and market volatility largely affects the returns in the short run. However, the effect of market risks gradually reduces and results into gains superior than other investments in the long term. So, you should enter the equity market with long-term vision and with adequate preparations to sustain the short-term turbulence.
Staying invested in equities for a long term would reduce the impact of market risks and generate a return superior than all other asset classes. So, equities may be used for long-term wealth creation, as they have the ability to beat inflation in the long run and the returns are tax efficient as well.
Let’s examine the impact of market volatility on short-term and long-term equity returns with some facts and figures.
The year 2018 was a volatile one for equity markets, which is an ideal situation to study the effect on equity funds as there was no steep rise of fall through the year. If we study the performance of systematic investment plans (SIPs) of diversified equity funds till November end, it will reveal a sorry picture for 1-year return, with 126 out of the 137 funds or almost 92 per cent of the diversified equity funds generating negative returns for the investors. The most battered funds were risky small-cap ones with as much as -33.3 per cent loss, while most of the 11 funds that gave positive returns were part of relatively lower-risk large-cap category with highest 1-year return of 5.75 per cent. By seeing the 1-year performance, you must be thinking, it would have been better to invest in fixed deposit (FD) with higher and guaranteed return.
Now move to 2-year SIP returns of the same category of funds. In two years, 42 out of the 137 funds or 30.66 per cent diversified equity funds had generated negative returns with steepest loss of -15.81 per cent and highest return of 13.13 per cent. Now the category is still risky, but the highest return, again from large-cap category, is nearly double the prevailing FD returns.
As we examine the 3-year returns of the diversified equity funds, we may see that the effect of market volatility further fades and only 5 out of the 137 funds or only 3.65 per cent of the funds end up in negative zone with maximum loss of -4.87 per cent, while the highest compound annual growth rate (CAGR) moves up to 14.03 per cent.
The 4-year returns see only 1 fund out of 134 funds has ended up in negative zone with -1.1 per cent return and rest 99.25 per cent funds giving positive returns with the highest CAGR of 14.56 per cent and average CAGR of the category hitting 7.81 per cent, which is equivalent to prevailing FD interest rates.
From fifth year onwards, the impact of market volatility was completely faded out and no diversified equity fund had given negative return. The 5-year average CAGR of the category hit 10.45 per cent mark, with highest CAGR of 19.05 per cent of a small-cap fund and lowest of 2.51 per cent of a mid-cap fund.
The average 6-year CAGR of diversified equity funds category was 12.91 per cent, with highest CAGR of 23.11 per cent and lowest of 3.47 per cent, while the 7-year average CAGR was 13.98 per cent, with highest of 24.26 per cent and lowest of 3.32 per cent.
As we move to 10-year performance, the average CAGR was 14.15 per cent, with highest CAGR of 21.77 per cent and lowest of 8.17 per cent and the 12-year average CAGR was 12.78 per cent, with highest of 19.58 per cent and lowest of 7.59 per cent.
Going to further long-term performances, the 15-year average CAGR was 13.47 per cent, with highest CAGR of 18.36 per cent and lowest of 7.86 per cent, while the average 20-year CAGR of the diversified equity funds category was 18.18 per cent, with highest of 22.01 per cent and lowest of 10.78 per cent.
So, you should not invest money, which may be needed in less than three years, in equity MFs and should enter into equity investments only with the goal of generating long-term wealth.
However, to sustain the short-term volatility, you should have conviction on the long-term wealth creation ability of equity by setting your long-term financial goals before starting investments. If you know how much risks you should take to reach the goals and find that there are no other ways to reach a long-term goal without the roller coaster ride of stock markets, you will get into the equity investments with determination, which will help you to ignore the short-term volatility as your eyes will be set on long-term targets. Otherwise, aimless investments would drive you out of the equity during market turmoils, resulting in booking losses.