Risk comes from not knowing what you are doing

Risk comes from not knowing what you are doing

Very recently, there was an interesting article in one of the leading newspaper (click here) which enumerated that an individual investing into fixed deposits of a commercial bank would make more money than by investing in the equity market over a 20 year time horizon. This really got us thinking – Is that so? How is it possible that a risk free instrument will give a return higher than a risk instrument and that too over a longer tenure. This was going against our basic belief that “risk reduces with increase in time”. The article is indeed very well articulated but we feel there are a few points which one needs to look at before coming to a conclusion and we hope that this article will provide some clarity and value-add. Our objective is not to say, that investing into FD's is wrong. The goal of any investment should be to derive the  maximum possible benefit because, ultimately it is our hard earned money that is being invested.

Point of Entry: The premise of the analysis is based on the assumption that the investor would have made the investment on a particular day in March 1992 in Sensex. Sensex in 1992 can be considered to be at the peak of a pushed up rally spearheaded by Harshad Mehta, which led to a steep correction in the following year and stagnancy for a couple more years. However, by just changing the entry point by a year on either side the returns would have witnessed a major change. Had the investor started investing in 1991, he would have made a return of 13.38% p.a. instead of 7.26% p.a. as claimed by the author of the article. Likewise an investment started from 1993, the investor would have made a return of 10.91% p.a., much better than the returns from the FD for similar tenure. This tantamount to a nearly 84.30% increase in the returns. A million dollar question which arises is; What is the right time of Entry? There is no right time or wrong time for equity markets. These will always be volatile and the best method is to invest regularly over a period of time. See our point below for more elaboration.

Dividend Yield: Benefits derived in the form of dividends declared by underlying companies has not been considered in the analysis. This is an important indicator as it provides a regular and consistent tax free income stream in the hands of the investors. Though the portfolio is assumed to replicate the Sensex returns, the constituent companies do declare dividends to its holders. The average Dividend yield of Sensex constituent, for the period in consideration, works out to 1.45% p.a. If this yield is added, the equity returns would work out to be 8.71% p.a., which would be higher than the post tax returns earned by an individual in the lowest tax bracket (explanation in the following section). This additional benefit is totally absent in FD’s and they would not gain anything more than the stated interest rate at the time of issue.

Impact of Taxation: A critical aspect for any type of investment is the impact of taxation. The analysis ignored the impact of taxation on the returns earned by the individual. The returns on Fixed Deposits are compared at pre-tax level, whereas in reality interest income is taxable as per the tax slab of the individual (which at present ranges from 10%-30%) while gains on equity shares held for more than a year is tax exempt. If we factor this impact on the returns, then for an individual in the highest tax bracket (30%, assuming that the same rate prevailed throughout the period, though the highest tax rate was about 40% in early 1990’s), the value of Rs.1000 invested in 1992 as per the article would be worth Rs.3,509 today, a post-tax growth rate of 6.16% p.a. which is less than that of the equity returns of  8.71% p.a. Following is the graphical representation of the returns at different tax slabs. As can be seen, at any tax bracket, in the long-run taxation significantly alters the total returns earned.

Tax Slab	10%	20%	30%
Investment (Rs.)	1000	1000	1000
Post tax Return (Rs.)	4952	4172	3509
Rate of Return (%)	7.92%	7.04%	6.16%

Regular Investment: One of the major shortcomings in the study was the assumption that all investment was made on the last day of the financial year 1991-92, and completely overlooks the benefits derived from investing on a regular basis. To be successful in any facet of life, there is one thing which is most important – discipline. Investing activity should neither be a Year-end exercise or some lumpsum investment made on a irrational basis but should be done on a regular basis. Had the same individual had made fixed monthly investment into Sensex from March 1992, he would have earned a return of 11.60% p.a. during the period and in addition would have received a dividend yield of 1.45% p.a.

Conclusion:

The article acts as a myth buster even for us, as many a times we take such analysis at face value without giving a second thought about the completeness and effectiveness of it. Today we have a lot of media overload and one needs to be careful before taking a decision. One needs to spend a few minutes in knowing whether even our understanding is attuned with it. In this age of information overload, a lot of data can be sourced from various places about any investment product in a very little time and enabling us in taking wiser decisions.

To sum-up, as Warren Buffet says “Risk comes from not knowing what you are doing”. A little bit of homework on your investments not only would improve your understanding about it but will also enable you to question your advisor.

Market Review - Feb 2009

The past few months have been extremely volatile in respect of all asset
classes be it equity; debt or commodities (gold in particular). The equity
markets have moved from 9,648 to 8,822 in the last one month, before
settling in at a close of 8,892 on 27 February, 2009. The bond yields have
fluctuated during the month, with 10 yr Gsec currently trading at 6.20% and
Gold has oscillated between Rs. 13,938 to Rs.15,979 per 10 gms in the last
one month; currently trading at Rs. 15,350 per 10 gms.

We are now entering the Election phase and should not expect any more Policy
announcements from the Government. The Interim Budget presented on 16
February, 2009 was a lot on hype and less on deliverance. The Finance
Minister kept on raising the hopes of making some changes but I guess the
code of conduct prevented him from doing anything dramatic. The alarming
part however, has been the level of fiscal deficit. This has reached a
significantly high level (expected to be around 6% of GDP against the target
of 2.5%) and is quite alarming. As a consequence the Government s borrowing
program is fairly large and this is having an extremely negative impact on
the bond yields.

World over we are witnessing a softening interest rate policy and in India
this just does not seen to be happening. The cost of borrowing is still very
high despite the fact that the corporates need access to cheaper funds.

Inflation, as expected has been steadily going down and has reached 3.36%
for the week ended on 14 February, 2009 and we expect it to touch 0% by June
end and will not be surprised if the level is even in negative territory.
GDP for Q3 has dipped to 5.3% against an expectation of 6 - 6.3%. This was
in line with the Industrial Production Index (IIP) which saw a dip 2% from
the corresponding period last year. So our PM & FM who have been harping on
7% GDP is all gone to the dogs.

The other myth which has been shattered is that our economy is inclusive and
the domestic consumption will drive our growth. It is high time we realize
that we are an integral part of the global economy and what better indicator
one needs then the substantial fall in the GDP from 9% to 5%; fall in the
equity markets and the rise in the US dollar vis a vis Indian Rupee.

So what does one do Going Forward from here? Expect the pain to continue for
atleast the next 2 quarters of the Financial Year 2009-10. We have not
created this crisis, so nothing much can be done at our end to solve it. We
need to let the storm subside. Markets may test new lows in the coming
months.

In the present market, if one is skeptical of all instruments, one can look
at Arbitrage Funds which will give reasonably good returns with a time
horizon of 3 months. Moreover, the present levels make it extremely
attractive to start a SIP in an Index Oriented Fund. Consider the following
example:

If one assumes that the markets would go down @ 5% every month for the next
6 months from the present level (8,607 to 6,660) and thereafter it would
start rising @ 5% every month for the next 6 months. The Index would thus be
at 8,924. Simple maths would tell us that Index has gone down by 30% (5% *
6) and again up by 30% (5% * 6), so there is NO GAIN or LOSS, RIGHT. Do you
know, the annualized return of the portfolio would be 30.50% p.a.

THINK ABOUT IT!

Lessons from 2008

The Interim Budget did not offer any sops which keeping in line with the convention is correct. However, the statements made by the Finance Minister during his speech were totally contradictory. As a consequence the markets have reacted quite adversely.

A major cause of concern will be the mounting fiscal deficit which is expected to touch 6% of GDP. This is going to have an extremely negative impact on the cost of borrowing, which will in turn have serious repercussions on Corporate India. At one side there is a need to reduce interest rates to propel growth but on the other hand the Government borrowing program just does not seem to end. To add to that we have the costs associated with the implementation of the sixth pay commission.

With Elections round the corner and no major policy decisions expected, we are all in all heading for tough times ahead, atleast for the next 3-6 months. Markets will be extremely volatile and will have a more downward bias. In the last two days itself the Sensex has lost upto 600 points; due to this heavy sell-off 155 BSE stocks have touched their 52-week low including many ‘A’ group stocks.

In this issue we thought of going back into the last year and see what we need to learn and avoid in the future. We hope to have covered some important learning experiences.

Click Here: Lessons from 2008