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.