Higher the risk higher the return

Higher the risk higher the return

The above statement is what is very common when one evaluates for investment . It is said that when you want higher return you should take higher risk but it is also said that it is not necessary that when you take higher risk you are sure to get higher return . Many investor get confused with this . Some even start thinking if there is not surety of higher return when I take higher risk then why I should take higher risk.  

First we need to understand what do we mean by risk. For a common man it mean loss or chances of negative return . But risk in investment means uncertainty in expected return  . In other words if there is more probability of getting expected return it is less risky and if there is lesser probability of getting expected return it is more risky .

So Probability factor becomes a very important measure for risk. What are the factors that affect the probability – nature of asset , nature of security , time , economic factors, market dynamics, people expectations  etc

Most Indians refrain from investing in Equities as their understanding about risk from equities is not correct . They think it as stock price , indices only . These price and indices are symbolic representation at any point of time whereas equities are in larger terms linked with people growth aspiration ,better living aspiration . These leads to demand for creation of more and quality product and services by some or the other companies or industries . This will lead to valuation , revaluation and new price discovery of stocks and rise of indices . The constant valuation, revaluation and price discovery leads of volatility in short term but in long term quality always dictates its term and any investment in such equities lead to  much higher return. So when we say higher the risk it implies the tolerance level and patience level in short term when there is volatility . If selection of investment in good company is done then good return will come soon and later .

Some can argue what is there is economic slump ( like recession in 2009 ) . Yes there might be negative impact on return may be of some months or up to few years . But again if you believe in law of nature then again not to worry . We have seen even after the worst of cyclone , tsunami when the whole village or town is destroyed first nature cools down and people again work hard to restore lives and infrastructure back to normalcy or even better . So always remember there is one truth of this whole world – everyone strives for growth and betterment . All nations, all economies , all corporate , all individuals all want growth and so the economic slump will not last forever and growth will come sooner or later as growth again is linked with our aspirations and better life which is through some products or services and investment in the equities of those companies will ALWAYS give you a higher return .

So we can say higher the risk tolerance ( showing patience by staying invested and not getting affected by volatility ) in short term but invested in good quality equity ( i.e stock of those companies which are producing good product in demand ) there is ALWAYS a higher return and no risk of losing in long term.

Debt Mutual Fund vs Bank Fixed Deposit – An analysis

·         Why an investor prefers Bank Fixed Deposit over Debt Mutual Fund – it is assurance of fixed return which can not be guaranteed in Debt Mutual Fund . Its also the safety of capital which again in not guaranteed as Debt Mutual Fund is market linked .

·         So what adds confidence to investors – Assurance ( clearly stated ) or Fixed return or safety of capital or all ?

·         Assurance from a credible issuer has value (i.e bank Fixed Deposit and good rated Company ) . Assurance from lesser rated debt Fixed Deposit is hardly preferred so assurance is linked with quality of issuer .

·         Safety of capital is again linked with the credibility of the entity whose Fixed Deposit purchased i.e good rating ones . Banks are considered to be most credible .

·         Fixed return is a percentage return in numbers ( e.g 8% )conveyed while investing but when redeemed does the investor gets  in hand the same return what he was expecting ? In notional terms yes but in real terms , no. He gets a net return which is lesser than gross return ( what has been communicated ) due to inflation and taxation . so if inflation is 5% the net return reduces to 3% . Further you have to pay tax as per your tax bracket on gross and not on net after adjustment of inflation . So net final return will be further less and can be even negative .   what is important – what is told or what you get in actual ? 

·         If one get in actual ( in hand ) lesser than what assured can this be called assured in real sense .

·         So now we need to evaluate Debt Mutual Fund on these 3 perspective – Clearly stated ( assured ) , safety of capital i.e will get back principal and fixed return what has been clearly stated .

·         In Fixed Deposit you are a lender . Its the borrower ( Bank OR Cos ) which decide what return you will get and you have to choose from whatever offered .

·         In Debt market the return is decided by borrower . Govt of India being the biggest borrower sets the lending and borrowing rate pattern in the economy through RBI through RBI by repo and reverse repo rate. No entities in the organised market can lend the money at a lesser rate than repo rate .   

·         Lending rate of Bank  > Deposit rate in bank Fixed Deposit ( of same maturity ). Obvious reason is banks should have some margin for operation and profitability . Also if it is the other way round there it will create an arbitrage opportunity for investor i.e borrow at cheap rate from bank and invest in the same bank at higher rate and gain  . Yes there are arbitrage opportunity but one has to risk his capital in lower rated company or exposure in interest rate derivatives . 

·         in Debt MF you are a not a lender but a proportionate owner in the fund as per your investment which is denoted by nos of units you hold .

·         Its obvious that as an owner you will always like the best possible return along with safety of capital as well .

·         Lets analyse safety of Capital first . As communicated earlier it has to do with creditability of borrower . In Debt Mutual Fund after doing a thorough research the best of companies in terms of profitability , safety are filtered and then money is invested in some of those good companies / issuers debt instruments .  So research ensures you quality ( safety ) and diversification ensures not exposing your money to one or few companies but more ( additional safety )

·         Fixed Return – If bank has lent money to Corporates etc it will get interest on regular basis . If money invested by Debt Mutual Fund in good debt securities will the fund also not get interest? It will also earn interest . Further here money is not invested in one particular yield i.e money is invested in Debt securities of different rating ( AAA, AA+, AA, AA- ...)  and also debt securities of different term to maturities ( few month to few year ) . Combining these two aspects the fund strives for a higher but safe return  .

·         If in a Debt Mutual Fund there is no assurance on return but that does not mean an investor should doubt on safety . Safety is assured from the quality of company and its profitability which is well taken care . Non assurance of return in any mutual fund product is because investment is done in marketable securities ( i.e those securities which are bought and sold ) where prices can change on daily basis and as securities are valued daily based on market prices assurance can not be given .

·         In a Debt Mutual Fund credit or default risk is well taken care by ensuring money invested in good quality company . Yes there can be interest rate risk ( Price of the debt securities can go up or down with the decrease or increase in interest rate ) but investor worry is  downside risk ( market value of security going down  ) only when interest rate rises .

·         If interest rate rises and you are in Fixed Deposit non cumulative option you don’t gain as your interest rate was fixed . When interest rate fall there also you don’t lose for same reason . If bank has assured of 7% per annum return on 3 year deposit then if next year interest rate changes to 6% or 8% you get the same 7% in a fixed interest Fixed Deposit But in Debt Mutual Fund if interest rate rises the market value of debt securities go down but at the same time the coupon interest earned can be reinvested at a higher rate  . In case in Debt Mutual Fund if interest rate falls the market value of debt securities goes up but at the same time the coupon interest earned can be reinvested at a lower  rate . So we see that some portion of rise and fall gets nullified by fund manager in Debt Mutual Fund.

·         What could be interest rate movement in short term is not a big puzzle so in a Debt Mutual Fund the Fund Manager is well aware of possible move and protects the portfolio market value in case of uprise in interest rate by either going for floating rate debt securities or more allocations in short term debt securities as there the fall is lesser compared to long term debt securities . In case he expects lowering of interest rate then he will have more allocations in long term debt securities as there the rise in market price is higher than  compared to short term debt securities .

·         A contra judgement on interest rate movement can only lead to large loss which is a very very rare possibility . In probability terms it can be 1% whereas 99% times judgement is right which can be validated by historical  data last 5 decades of MF .

·         One fear in the mind of investor could be safety of capital. What if a company which was good ( profitable ) when invested became bad ( non profitable ) later on . One major difference between bank or any Fixed Deposit is that the money given to company as loan get struck up till maturity whereas in Debt Mutual Fund the money invested in tradeable security . The research wing keeps monitoring the financials , operation and management of the company where invested and if they get any negative feeling the fund manager sells those debt securities  much before the market realises , thereby avoiding creating of any NPA in the fund portfolio . Again historical data are there for cross checking .

·         In Fixed Deposit you get a fixed return but Debt Mutual Fund you get fixed return plus there is scope of capital appreciation .

·         Regular / periodic income earned in Fixed Deposit is called Interest whereas the same in Debt Mutual Fund is called Dividend . Dividend is tax free in the hand of investor whereas interest income are taxable .  Fixed Deposit has TDS but there is no TDS in Debt Mutual Fund.

·         Interest in Fixed Deposit is fully taxable . Bank deduct TDS @ 10% initially but the whole interest income to be taxed as per income slab whereas dividend is tax free in the hand of investor . Its only the Dividend Distribution Tax  which on the gross dividend is much less ( approx 28.33 % of gross dividend in case of individual ) .

·         There is no capital gain in case of Fixed Deposit so no tax . In case of Debt Mutual Fund if redeemed before 3 years the gain is taxed as per marginal tax bracket where investor lies . For a period more than 3 year Debt Mutual Fund gives better return net of tax as there is indexation benefit which is not in Fixed Deposit. Here the gain is taxed @ 20% with indexation benefit . In Fixed Deposit you get he same principal back in notional term but in fact it is less as inflation has reduced the real value . In Debt Mutual Fund you are compensated for loss due to inflation due to indexation benefit .

·         In a Debt Mutual Fund you have a flexibility of managing your cash flow need either through dividend option or partial withdrawal as and when you want or through Systematic Withdrawal Plan if the requirement is periodic and fixed . You can stop SWP any time, change the amount any time.  In Fixed Deposit withdrawal allowed but again not with so flexibility or ease .

·         You have easy flexibility to move from  debt to equity and vice versa through Systematic Transfer Plan in case you want to take advantage of equity market or protect your investment value if equity not doing well whereas not possible frequently and with ease in Fixed Deposit. 

Attractiveness of Indian Equities

Attractiveness of Indian Equities  

Analysing strength of Rupee first

·         The level of our currency depends on many factors but the two most critical factors are fiscal deficit and current account deficit

·         Fiscal deficit is the difference between what your government earns and what it spends .

·         India being a growing economy and also due to lots of social benefit schemes spending has always been on rise  .

·         Earning is taken care by Taxes + Borrowings in case of shortfall

·         If Spending > Earning and taxes are not able to compensate then more borrowing by Government

·         More borrowing means more pressure on payment and when you borrow a lot, your credit profile in the outside world goes down thereby rupee at times become weaker .

·         Current account deficit is the difference between what India exports and what India imports.

·         Our imports have always been higher than exports, resulting in high demand for US$

·         The twin impact of high fiscal deficit and high current account deficit resulted in high demand for US$ and kept the Indian Rupee under pressure .

Will Rupee expected to get Stronger from its present level next 5 years ?

·         Over the past three years, India seems to have solved both the above mentioned problems

·         India’s fiscal deficit has reduced by ~Rs. 1,50,000 crores over last two years because the current government is spending less and earning more . The current government has made the previous government populist policies more efficient by bringing transparency and accountability in operation ..

·         On the revenue front, India’s tax collections grew at 18% in FY17, the highest in last seven years. Most of the gains due to declining oil prices .        This government’s relentless focus on tax compliance has also helped (demonetization was one of the many steps in this direction).

·         The current account deficit  problem has been solved through structured control over gold import , incentivising domestic physical gold savers  by offering various financial products like gold bonds and ETFs.  India’s import bill has reduced by more than Rs. 400,000 crores or US$61bn.  Thus, India needs far lesser US$ now than two years back. It’s only natural that Indian Rupee should

become stronger.

·         This indicates strength of Indian economy .

How can you benefit from this trend of strong rupee?

India seems to be more stable economically in a relatively unstable world economy.

·         FIIs inflows in Indian equities has been phenomenal ( US 40 billion last FY ) . They hold approx 25% on Indian equities vis a vis 15% held by domestic mutual funds . It seems they have confidence in Indian equities .

·         Domestic investors savings moving to equities and not in real estate and Gold . Declining FD rates also motivating investors to go for equities .

History  --  Past 10, 15 years Indian equities have given one of the best return

Present  -- A stable Government trying to control corruption ( subsidy directly to bank account , demonetisation ), increase in taxation ( , proper allocation of resources , economic reforms ( GST )

Future – Strong consumption pattern, focus on self reliant economy etc will boost growth and economy thereby more return through Indian equities . Risk from equities can be minimised by investing in good equity mutual fund products .