There are a few ways to look at returns. We can compare how much we are earning on our investments with either a risk free rate, or average returns from equity markets, or just compared to an absolute number.
Compared to the risk free rate:
The risk free rate is indicated by the coupon rate on the Indian government bond. As the returns from the government bonddecrease, the incentive to take risk increases – so do stock prices. Also, as the interest rates go down, money becomes cheap and businesses can borrow easily, hence encouraging spending and capital expenditure. This, at least, is the theory behind interest rates. In practice, this issue is more complicated and outcomes are unpredictable.
Compared to the estimated future equity returns:
Indices like the Nifty50, Nifty200, or Nifty500 make up most of the capital invested in the equity markets. They constitute 70%, 90% and 98% respectively of the total capital invested in the Indian equity markets. Which means that the top 500 stocks (by market capitalisation) can be considered a proxy to “the market”.
For any rolling 5 or 10 year period you would generally see 15% returns compounded annually on these stocks. This means we need to do better than this in our portfolio in the long run to make “active” investing worthwhile. Otherwise we could take the “passive” route and merely park our money in a low-cost index fund that invests in the stocks of the index to replicate its performance. We would then be getting market returns by doing nothing.
Returns can be compared to the general returns of the stock market indices to see how your portfolio is doing.
Absolute returns
Ideally, the portfolio performance should disconnected from the swings of the market. You would prefer to make a profit regardless of how the markets are doing. This is not always going to be possible, especially in severe or prolonged bear markets. However, it might still be possible to create a good mix of stocks which tends to go higher year after year as a group. While this is not possible all the time, it is definitely a goal worth pursuing, and better than tying our performance to an index that has a lot of factors affecting stock price movements.
Also, at 15% money doubles every 5 years. If we are unable to achieve such numbers, then we need to think hard if it is worth the effort to even do equity investing full time. So this forms what is called the MARR (minimum acceptable rate of return) for stocks. Unless we see the potential of the worst case scenario paying us 15%, we shouldn’t buy the stock.
Hence long term portfolio returns should ideally be compared to absolute numbers that focus solely on how much beyond 15% can we achieve.