For many of us, when we think about investments, the focus is mostly on returns. Not unfair. Everybody wants an adequate reward for the risk taken. However, when you think in terms of financial goals or financial planning, return is not the only part of the equation.
Let’s look at the
equation for compounding.
A = P * (1+r)^n
Where P is the
amount invested, r is return per annum (period) and n is no. of years
(periods).
It is quite clear that the amount invested (P) is important too and deserves a lot of attention.
Rs 1 lac will grow to Rs 6.72 lacs in 20 years at 10% p.a.
Rs 2 lacs will grow to Rs 9.32 lacs in 20 years at 8% p.a.
“How much you invest” matters.
It is for this reason that it is important for young investors to focus more on enhancing their investment ability (careers) than getting fascinated with returns on their investments.
Financial Planning and Investing more
From the perspective of financial goal planning, the investment amount is extremely important. To arrive at the monthly investment required to reach a goal, you need a
- Target amount
- Time to the goal (or investment horizon)
- A rate of return.
Everything else being the same, the more time you have, the less you will need to invest per month.
Higher the rate of return assumed, the less you will need to invest per month (everything else being the same). You can make very optimistic assumptions about returns and be content with investing a low amount each month.
What are the pitfalls of high return expectations?
By working with very high return expectations, you reduce your cushion.
Let’s consider an example.
You need to
accumulate Rs 50 lacs over the next 15 years. How much should you invest every
month?
You are a very
aggressive investor. You believe that you will earn a return of 15% p.a. With this
assumption, you need to invest Rs 8,200 per month. You put 100% into equities.
Your friend is a relatively conservative investor. He assumes a return of 10% p.a. He needs to invest Rs 12,500 per month. He puts 50% in PPF and 50% in equities. His equity holdings are the same as yours. Just that his portfolio is split equally between PPF and equities. He rebalances at regular intervals. There are limits to how much you can invest in PPF every year but let’s ignore that part.
Who would you
think is more likely to achieve the goal? Perhaps the question is not right. The right
question should be: Who faces greater risk of not meeting his goal? You or
your friend?
Assuming if PPF returns 8% p.a. (compounded) and equity investments happen to deliver an IRR of 15% p.a. Both of you will reach your target corpus of Rs 50 lacs. Your friend would experience a return higher than 9% p.a., so he would end up with a corpus higher than Rs. 50 lacs. However, by assuming a lower rate of return, he invested more and built cushion for himself. He can use the excess money for any of his other goals.
Risk means More things can happen than will happen. (Elroy Dimson)
What if you underestimated
your goal requirement and you need Rs 60 lacs (and not Rs 50 lacs)?
What if the IRR on equity investments was only 10% and not 15%?
You will end up
with ~Rs 33 lacs. Short by 34%
If the IRR turned
out to be 8% p.a., you will end up with ~ Rs 28 lacs. Short by 44%.
Even though I can’t say what your friend will end up with because the annual rebalancing can throw up different results for different sequences of returns for equity investments. However, he will be much closer to the goal than you are. Just to cite an example, if the equities were to give a constant return of 8% p.a., your friend will have Rs. 42.5 lacs at the end of 15 years. Your friend is still short of Rs 50 lacs but is short by far lesser amount (you ended up with Rs. 28 lacs). His portfolio would have experienced lesser volatility too.
You and your friend keep exactly the same portfolio
Now, let’s
consider another scenario.
Forget about the
PPF. You and your friend keep the exact same portfolio.
You and your friend keep exactly the same portfolio. Just that you assumed a return of 15% p.a. on the same stocks/mutual funds while your friend assumed 10% p.a.
You invest Rs 8,200 per month. Your friend invests Rs 12,500 per month. The two of you invest in the same stocks, on the same date, at the same time and in a similar proportion. You experience the same volatility too.
Since everything else is the same except for the quantum of investment, both of you will experience the same IRR.
At 15% p.a. IRR,
you have Rs 50 lacs. Your friend has ~Rs 77 lacs at the end of 15 years.
At 10% IRR, you
have Rs 33 lacs (short by Rs 17 lacs). Your friend ends up with Rs 50 lacs.
At 8% IRR, you
have Rs 28 lacs. Your friend ends up with Rs 42.5 lacs.
As you can see, your friend has a better cushion since he invested more. Even if things go a bit wrong, he will still be fine.
The resources are limited
That’s right too. You
do not have infinite resources.
If you can invest only Rs 50,000 per month, that’s it. No matter what return assumption you work with, you cannot invest more than that.
A 10% long term return
assumption might require you to invest Rs 90,000 per month but you can’t invest
more than Rs. 50,000.
However, in my
opinion, even this information has tremendous value.
When you use a reasonable assumption and realize that you are not investing enough, you can take action to manage the situation. You can look for a higher paying job. You can look towards cutting down unnecessary expenses. Rather than making a constant investment, you can increase investments every year with salary hikes.
You can’t treat an illness unless you diagnose it first, can you?
What can you do?
When you are deciding upon amounts to invest for each of the goals, do the following.
- Keep your return expectations rational. Don’t work with assumptions of 18%, 20% or 25% equity returns. Such returns may not materialize. As retail investors, we may experience such higher returns over a short period of 2-3 years. However, it is not easy to get such high returns over the long term. You will only end up under-investing for your goals.
- A lower return expectation will force you to invest more and build a cushion for your portfolio.
- Work with an asset allocation approach. Rebalance at regular intervals. Portfolio Rebalancing may not always enhance returns but is likely to bring down volatility in your portfolio.
- If after working out the numbers, you realize that you are not investing enough, try to remedy the situation.
A couple of caveats
Do not take this to
the other extreme. 10% is more
conservative than 15%. 6% is conservative than 10%. Lower the assumption,
higher the cushion will be. However, as we discussed earlier, we don’t have
infinite resources. Therefore, you need to draw a line.
Your return expectations will also influence your choice of investments. If you think you will earn 6% p.a. over the next 20 years, you may end up picking very safe but low yielding products like bank FDs. This can be harmful to your long-term goals and may not be the smartest decision.
More importantly, with limited resources and very conservative assumptions, you may simply give up or become too obsessed with investing. Neither is good. You need to enjoy your life too. Money is merely a means to an end, and not an end in itself.
The post was first published in April 2019.
