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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Investment returns = Market returns = Earnings growth

Posted by Muthu on November 6, 2014

In the last 35 years of Sensex history, there has been totally 8110 trading days. Out of this, Sensex has hit new highs in 499 days. (Source: https://twitter.com/bemoneyaware) .

So every 6% of trading days, Sensex has been hitting new highs. It would continue to hit few hundred new highs in the next 2 decades. This is very normal. So no need to feel scary when you read about Sensex hitting new highs. This is how it is.

Since the beginning of June this year, the Sensex has hit new all time highs 22 times in barely 100 trading days. Enjoy the ride.

I want to explain a small concept in this piece.

Our investment returns are based on earnings growth, where as market returns are Investment returns (+) or (–) Speculative returns.

To illustrate, let us assume that the earnings (EPS) of Sensex grows 15% in a year. So our investment returns are also 15%. Since market returns rarely match investment returns year on year, the difference between investment returns and market returns are called speculative returns.

In the example given above, the Sensex earnings grows at 15% in a given year; if the market returns, as measured by Sensex levels, is say 25%; then the speculative returns is 10% (25-15). In the same example, if the Sensex has gone down by 25%, then the speculative returns is -40% (-25-15).

In the first case, for 15% growth, we got 25% returns. In the second case, for the same 15% growth, we got a negative return of 40%. This would always be like this if we look on a year to year basis.

But many studies have pointed out if we take long periods for measurement, market returns are on par with investment returns. Speculative returns become almost zilch over the same period. Since over long term the market returns are same as the earnings growth or investment returns; there is no need for any concern. We’ve to ignore the speculative returns and stay the course. Negative speculative returns would always be offset by positive speculative returns and vice versa.

At the cost of repetition, we’ve to focus only on the investment returns (earnings growth) and not the speculative returns. Speculative returns are positive for some years and negative for some years; but over long term, tend to be zero. So we can be rest assured that what we would receive over long term is the actual investment returns.

(Note: Investment returns include dividend yield in addition to earnings growth. I’ve kept it simple to confuse you less:-))

The market returns in the long run would be in tune with the growth of the economy. Assuming an 8% growth rate (we’ll be there) and 6% inflation, economy may grow at a nominal rate of 14% every year. So the investment and market returns can never be more than this number. But individual stocks or funds can give better returns based on how well the portfolio is structured. Good companies in a growing sector can give 1.25 to 1.5 times more than the economic growth, especially given the low base and growth potential of our economy. So my expectation is that 18%+ annualized returns for next one decade is very much possible.

In the short run;

Investment returns = Market returns= Earnings growth (+) or (-) Speculative returns

In the long run;

Investment returns= Market returns= Earnings growth

What matters to us is long run.

One Response to “Investment returns = Market returns = Earnings growth”

  1. nicegem007Murty said

    Suppose , you invest in a stock, which gave 100% returns in one month, you sell half of the same, and retain the rest at zero cost. What would be the returns on the same over one year, 10 years and twenty years?

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