Investing Fundamentals Part II: How to generate higher returns?

Investing Fundamentals: How to generate higher returns?

This is part 2 out of a three-part series of investing fundamentals. To read part 1, go here

The key take away from part 1, was that Inflation is going to eat into your corpus every year unless it keeps growing at a rate faster than 7% p.a. 

The question we will look at now is how to grow faster than the inflation rate, and some myths about Equity investing.

Let's take look at the options a salaried individual has today to structure their investments. 

Investment options in India

In the table below, I have summarised the investment options based on the returns, possible tax benefits, time to maturity, and the risk.

Scheme	Return (p.a.)	Maturity	Tax Rules	Remarks	Risk
FD, RD	4.5%	6 months to  2 years	Interest is usually taxable;  Can get a Rebate for a 5-year term deposit u/s 80C	Fixed sum to be deposited monthly for RDs	Low
5 Years National Saving Certificate (NSC)	6.8%	5 Years	Rebate u/s 80C of up to Rs 1.5L;  Interest Exempted;	No Limit to max investment;  Interest rates are subject to change	Low
Public Provident Fund	7.1%	15 Years		Investment limit Rs1.5L p.a.	Low
ELSS	~12%	3 Years		No limit to maximum investment	Medium; Safer than equity because period is at least 3 years
Employee Provident Fund	8.5%	Retirement	Tax Exempted up to 2.5Lpa  –2.5L is your contribution, not employer’s –rebate is over and above 80C	Interest rates are subject to change	Low
National Pension Scheme	9-11% (based on equity allocation)	Retirement	Tax Rebate upto50K pa, u/s 80CCD (above 80C)	Maturity: 40%-60% as lumpsum, rest as an annuity	Medium; Return may vary but the holding period is very high, reducing the risk
Govt bonds/ Debt MFs	~4%  (fixed return)	N.A.	Long term capital gains tax of 20%	Can purchase in cycles. When the interest rate goes up, the bond price goes down and vice versa.	Low risk if you hold through bond period, but  Medium risk for short term trade
Equity - MFs/ Index ETFs	~12%	N.A.	Long term tax 10%, short term 15%; 0 below Rs1L	Recommended to choose the right MF or choose ETF as most funds don’t beat the index	High; Lower than direct shares because diversified
Equity - Direct Shares	~15%	N.A.	Long term tax 10%, short term 15%; 0 below Rs1L	Investment in shares is either fundamental trading or algorithmic	Very high; Can be reduced with longer term

Myth No 1: The alluring returns of govt backed EPF

One exception to the rule seems to be EPF: Employee Provident Fund, giving you an 8.5% return, which is a shade better than inflation. And this return is govt backed so ultra-safe. This is why a lot of people invest in this. 

So why doesn't everyone just invest in EPF and get a guaranteed safe return of 8.5%? 

There are multiple issues with EPF. 

1. You cannot withdraw at will. You can only withdraw when you change your job, retire, or some exceptional events like marriage or purchase of a house, etc. 

2. It doesn't give exceptional returns. You get a guaranteed 8.5% return no more, no less. So you will never see a return like 60% in a single year.

3. The maximum limit for availing tax free returns in EPF is 1.5L per year. You can add more but it will no longer be triple tax exempted.

So why have we heard so much about EPF as a great instrument for investments from our parent's generation? The truth is, there was a time that govt used to give a return of 11% in 2000-2002 on EPF. You can see the historical rates here. But today, rates have come down to 8.5% and only seem to be reducing with time. 

Now I am not asking you to neglect EPF completely, it still has great merits. But allocate your investments smartly, according to your risk-taking capacity. Keep some portion as a backup in EPF and as cash. But don't put too much in there. 

A backup will always protect your downside and make sure you never go down, though it may not make you wealthy due to limited upside.

So how much should you put? How do you allocate your assets?

Myth No 2: Asset allocation should be fixed by age

Actual amount that you add depends on your lifestyle, your city, your job etc, so we will not get into it here. How much of your investable income you choose to invest into Equity vs other safe instruments is what is under your control, and something we can talk about. And there is no exact rule here as well.

Many of you might have heard of the 100 - Age rule, to decide the Equity percentage. Eg. if you are 30 then you can invest 100-30 ie 70% of your assets in Equity. The main idea behind the rule is the number of years you have before you need to liquidate your portfolio.

But this is not a hard and fast rule, and age is only a rough measure of your risk-taking capacity. Your portfolio size and loans or debt and even your life/health insurance status make a lot of difference to this. 

In a 2013 letter, Warren Buffet revealed that his 75-year-old wife was going to put 90% of her retirement corpus into Equity, and 10% into govt bonds. But this doesn't mean that she is wrong. 

Warren Buffet's wife is an individual who has enough money to live out her life with just 10% of her retirement corpus. She doesn't need to liquidate her Equity portfolio for any emergency. So even if her equity portfolio falls by half, she can wait out another few years till it comes back up again.

Like her, you can choose your own asset allocation based on your risk-taking capacity.

The biggest doubt that comes now to your mind is when to invest in equity? The market seems too inflated right now, maybe I should wait for a few months to see where it goes.

Myth no 3: Timing the market

(Graph of NIFTY50 Index from Jan 2000 to Jan 2021)

Look at the graph carefully. The sections highlighted above are all from periods where Financial Analysts have given a solid reason for the crash or boom. Though retrospectively it is easy, at the moment it is very difficult to actually predict the direction of the market. 

Even in 2006 when the NIFTY had reached an all-time high of 3800, who knew that in two more years the markets would hit 6000!

Even in this post-Covid recovery, in March 2021, it had been a year of growth and analysts claimed that the market is overheated. We saw detailed graphs from various brokers floating around claiming that the markets would soon fall. Nifty was at 15000 levels at that time. Today the index is around ~17,500 levels.

If tomorrow an advisor claims that the market is too high right now and you should invest after a few months, or maybe the market is very low right now you must invest, let me tell you they are not sure themselves. Predicting the market is absolutely impossible. In the long term, it will grow, but in the short term, we have no idea what could happen.

Timing the market is a complete fluke or a very rare occurrence (like the 2008 or 2020 crash). 95% of the time, no one knows whether the market is overheated or undervalued. And when you are in it for the long term, you can only control your investment time in the market and asset allocation. 

The more time you spend in the market, the less variable your returns will be. Let us confirm this using a concept called rolling returns.

Below is a graph of the rolling returns (CAGR) of NIFTY50 over any 5 year period between 2008 and 2021.

Rolling Return	Max Return	Min Return
1 Year	99%	-50.9%
2 Years	16%	-12.2%
3 Years	2%	-4%
4 Years	5%	-7.1%
5 Years	6%	-1.2%

This tells you the maximum or minimum returns for NIFTY50 in any time period across 2008 to 2021.

And this number converges closer to the average returns as your time period increases. As you increase the time to longer than 5 years, your CAGR comes closer and closer to 12% (NIFTY long-term average).

And of course, we already understand the power of compounding from part 1 of this series. 

A 15% CAGR in 30 years is not 450%, it is 6500%!!

Think long term!!

Finally, the question that we all want to answer. How do I invest in equity? Are mutual funds okay? Can I simply buy index funds or Exchange-traded funds and forget about it? How to get that 15% CAGR over the long term?

These would be answered in part 3. Coming soon! :)