It is a normal perception in the minds of the average investor that equity is the best asset class to create wealth in the long term, but is that really true and should we focus only on the returns or risk-adjusted returns?
To think about it, even gambling is a good way to get a quick buck reward, but is it a good proposition for risk-adjusted return? “NO”.
Generally, we measure risk-adjusted returns by Sharpe ratio. The Sharpe ratio measures the performance of an investment in comparison with a risk-free asset, after adjusting for its risk. Higher the Sharpe ratio better the risk-adjusted investment.
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Broadly we have 3 asset classes to invest in- Equity, Debt, and Gold. If we talk about India, all of the above 3 asset classes have given almost the same returns over the last 25 years, but if we analyze risk-adjusted returns of equity against the others, we find that pure gambling would have been a better proposition than equity in terms of risk-adjusted returns and both Debt and Gold have given better returns and far better risk-adjusted returns in the last 25 years. The same story holds true for the US as well, considering data from the last 50 years.
|Asset Class||Past 25 years CAGR||Sharpe ratio|
|Govt Bonds (Debt)||9.88%||0.97%|
Further, generally, people consider that diversification of equities is a good tool to reduce risk exposure, but history has shown that diversified indexes have not given good risk-adjusted returns. Now the question arises, how is it that big investors like Warren Buffett or Rakesh Jhunjhunwala and others have become so rich by investing in equities?
In its March’2020 filing, Berkshire Hathaway (Warren Buffett’s flagship investment company) has reported that close to 70% of its total holdings are concentrated in just 5 companies. They don’t believe in wide diversification, and Mr Buffet himself has correctly said that “Wide diversification is only required when investors do not understand what they are doing”.
Equities are good but investing in a widely diversified portfolio and holding on for the long term (which most people think can be a foolproof way to create wealth) is perhaps not the right way to invest.
Of course, investors have their own limitation and not everyone can be a full-time investor and analyze companies as Warren Buffett does or a market professional does. And if wide diversification does not guarantee good returns even in the long term as data suggests, how and where can a normal investor really invest?
The key is the right allocation in uncorrelated asset classes. That and basic knowledge of the economy can make an investment really successful. There is no denying the fact that the economy works in a cycle and every point of this cycle gives an opportunity to invest in undervalued assets and sell the overvalued ones.
The concept of uncorrelated (or zero correlation) assets can be understood like this – If two assets are considered to be non-correlated, then the price movements shown by one asset has no effect on the price movements of the second asset.
Investing in uncorrelated assets reduces risk and increases risk-adjusted returns.
As can be read from the above data graph, there is only 11% probability to lose money if we have 20 uncorrelated assets in our portfolio, and 89% probability to get good returns in any type of economic environment, be it a recessionary or an expansionary phase of the economy!