Gentlemen prefer bonds!

"Gentlemen prefer bonds."
- Andrew Mellon (US Businessman, financier, philanthropist, US Treasury Secretary 1921-32. For some readers, Carnegie Mellon University might ring a bell)

It is 'common wisdom' that stocks are better investments than bonds, especially over long periods. After all stocks have earnings that grow over time while bonds only yield interest.

This might be true for single investments made over long periods. Many investors however make investments periodically, like a Systematic Investment Plan (SIP). Of course, SIPs are much advocated by the financial advisers as a prudent tool for market out performance over long periods. I had published 2 posts on this blog showing how SIPs in fact do not generate great returns even over long periods (http://shashankjogi.blogspot.com/2008/06/do-sips-really-work.html and http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html.)

But do SIPs even beat investment in debt? It will depend upon returns from equities and the prevailing interest rates. Looking at history, I tried to compare two SIPs.
-The first was an investment of Rs 10000 in the BSE Sensex on the first trading day of every month.
-The second was an investment of Rs 10000 in a 1 year Fixed Deposit of the leading bank in India every month.

The time period for the study was from January 1991 till December 2008. i.e. a period of 18 years.

Since exact data for fixed deposit interest rates is not available, I took at these as the yield on a 10 year Government of India security plus 1%. (Currently, this yield is around 5.5% while 1 year bank FDs are giving an interest of 8.5-10.5% depending upon the bank. So 1% above G-sec yield is a realistic assumption).

The results were surprising!

(1). BSE Sensex SIP:
A total sum of Rs. 2160000 was invested.
This became Rs. 5575010 (as of 30 Dec 2008)
This implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%

(2). SIP in Bank Fixed Deposit:
A total sum of Rs. 2160000 was invested.
This became Rs. 8076625 (as of 30 Dec 2008)
This implies a return of approximately 12.5% per annum.

The SIP in Bank FD beat the SIP in BSE Sensex!! Over a period close to two decades, SIP investing in debt beat SIP investing in equities!

Many of you might recall the high interest rates in the 1990s. At their peaks, FD rates had gone up to 17% while staying in double digits for the entire 1990s decade.

Post 2002, interest rates softened and fell into single digits. So one would have expected returns from FDs to be significantly lower compared to Sensex since the start the latest bull market in 2003. So how do the two compare?

(1). SIP of Rs 10000 per month into BSE Sensex since Jan 2003 done on the first trading day of the month:
A total sum of Rs. 720000 was invested.
This became Rs. 955836 (as of 30 Dec 2008)
This again implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%

(2). (2). SIP in Bank Fixed Deposit:
A total sum of Rs. 720000 was invested.
This became Rs. 921566 (as of 30 Dec 2008)
This implies a return of approximately 8.3% per annum

Even in a mega bull market, Sensex SIP could not significantly outperform the SIP in Bank FDs! FD SIP investors would have got returns somewhat lower than Sensex SIP but with no volatility and no risk...and would have slept much better than equity investors.

(Note that Bank FD returns are pre-tax figures)

The future is never like the past and conditions always change. Maybe in the future equities significantly outperform debt. Maybe this does not happen. We don't know, though I would tend to lean on the side of equities outperforming debt. But the study made above throws some points:
(1). SIP investing in equity is not necessarily a great tool for wealth building.
(2). Investing into equities is buying parts of businesses. Businesses are subject to competition and also have their ups and downs. Investing makes sense when businesses are available cheap. Investing makes sense when conditions for businesses are favourable. Stock prices reflect future business prospects and when prospects start appearing weak, equity investing loses money. Unless someone seeks mediocre returns, investing should not mean buy-and-hold-till-you-die. If someone wants to practice SIP investing, the same principle should apply. Do not get taken in by glib talk by some talking head in the media
(3). Learn to sell intelligently. It is selling that counts.

Sometimes, everyone should prefer bonds!