If the market sustains its momentum, the reverse will be true, when investors tend to go overboard on equities. It is at these times that one should understand equities for participation, with an understanding of the risks and rewards of investing in common stocks. This write-up is intended to help put stock market valuations and returns in historical perspective and provide some prudent guidelines that investors may find helpful in balancing risk and reward in their investment programs.

The stock market is volatile

Over the long-term, returns provided by common stocks have averaged over 20 per cent annually (based on 20-yearSensex performance). But this average return masks a great deal of volatility because returns from common stocks have fluctuated within a very wide band. Over the past eight years, the Sensex has provided annual returns ranging from a negative 24 per cent (in 1998) to a high of 91 per cent (in 1991).

This extreme volatility is the principal risk of investing in equities and that widely prevails over investors' memories after a long bear-run. Those who are new to investing in equities, may underestimate the potential of equity investments. And the way to manage this risk is to invest for a long-time frame. Time greatly reduces, although it does not eliminate, the volatility in returns from stocks.

One can draw at least three conclusions from the long-term equity trends (see table). First, time reduces the risks of holding equities. Second, there is no guarantee that one will earn the long-term average of 20 per cent a year even if the stocks are held for two decades, as this is a historical return. Third,years like 1990 and 1991 -- when the Sensex provided total returns of 33.82 per cent and 91.03 per cent, respectively, -- may already have provided a sizeable chunk of the returns that can reasonably be expected over the next several years.

Bear markets are part of investing

Investors, who are relatively new to investing in equities, may benefit from some perspective about bear markets (a prolonged period of falling prices). Although how steep and how prolonged a price decline must be to constitute a bear market is not defined. Although no one can reliably predict the timing of bear markets (or bull markets, for that matter), a prudent investor should understand the extent to which stock prices can decline and should be prepared to `ride out' these periods when they occur. The big danger from bear markets is that an investor will sell at or near the bottom of the downturn.

Reasonable expectations or surprises

Investment returns from equities over short periods (even periods of severalyears) are notoriously unpredictable. Which is why one should rely on long-term historical averages in setting their expectations about future returns. While these long-term averages do not predict short-term results, they may provide some clues as to what investors may expect over longer periods, such as the coming 10 to 15 years.

In recent years, the stock market has provided investment returns that is far below the long-term average and some measures of stock market value indicate that stocks are currently cheap compared with long-term historical averages. No one knows whether the stock valuations will move back towards their long-term averages quickly or slowly, or when such a trend may begin. Generally, there is considerably lower risks of investing in equities, especially when stock prices are low by traditional measures of value such as P/E ratios and dividend yields.

I am not attempting to predict the direction of the stock market. Instead, I am suggesting that the risks of investing in equitieshave been reduced in recent years along with the sharp fall in stock prices. Prudent investors will consider the stock market's low current valuations in forming expectations for future returns and in planning their personal finances.

How to manage risk

Although risk is inescapable when investing in common stocks, the greatest risk is that one will never invest in common stocks because you can never be sure when is `the right time' to invest. Uncertainty is a permanent feature of the investing landscape and trying to discern the ideal time to invest in stocks is almost always a futile exercise. Investors are better served by using time-tested strategies for managing risk. The following precepts have been used to good effect by successful investors in all sorts of investment climates: