Normally our minds are tuned with the law of Physics. For every action, there is an equal and opposite reaction. Hence, we are always under the impression that higher the returns, higher the risks undertaken. Thus, we come to our own conclusion that equity investments are risky by their very nature while fixed income instruments are safe investments. Equity investments appear risky due to the volatility in their prices, while fixed income securities appear safe as their prices do not fluctuate. In reality, the factor of inflation makes the fixed income securities much riskier. It can eat into your fixed returns. In contrast, equities are a good hedge against inflation. The following chart shows the returns on equities as well as returns from a fixed income instrument, Public Provident Fund, from 1979 to 2007. Stocks vs PPF Equities have returned 19.67% per annum over these years, while the returns on PPF have been just over 10.4% per annum. In economies where rising inflation is a reality we all have to live with, fixed income securities score very poorly. Equities as an asset class have performed exceedingly well. If one had bought the Sensex in 1979 and stayed invested, one would have made immense wealth. That is the power of equity investing. However, we observe that investors find the equity asset class dangerous due to its wild fluctuations, and many people shun equities as there are various examples of investors and corporations having gone bankrupt in equity investing. Value Investing and Behavioral Finance Isn't it a paradox that equity investments have done so well, but the investors have done poorly? Why is it that we have so many "rags to riches" and "riches to rags" stories in equity investing? Why are the stock markets known as glorified casinos? The answer lies in understanding investor behavior and its effect on stock prices. 2.1.1 Is Equity Investing Really Risky? Investing in equity is considered inherently riskier than investments in bonds. In spite of widespread acknowledgment about this risk-reward relationship of bonds and equity, little time has been spent on understanding what makes equities riskier than bonds. Is it due to the inconsistent performance of the companies behind the stocks? Or, has it got to do with the way the equities are approached and appraised by broader market participants, who are prone to fear and greed, leading to wide swings in returns for investors? It is the behavioral traits of the investor in particular and the crowd behavior of the markets in general which makes equity investing appear a risky proposition. Finding an answer to the above questions would not only help us put things in perspective but would also help us decide if it would really be prudent on our part to take the route of equities while deploying our savings, with the aim of generating better returns. Alternatively, we would conclude that the risk associated with equities cannot be reduced by an investor under any circumstances, and hence, she should shift his/her savings towards fixed income-generating securities, i.e., bonds. Let us try and find the answer to the questions by discussing the various sources of equity returns. Two Sources of Equity Returns Unlike bonds, wherein the returns are dependent on only one source under normal circumstances, which in itself is known beforehand, i.e., interest income, the returns from equities are dependent on two sources.