Tax Efficiency

Tax efficiency of a financial decision is the degree to which tax burden is reduced vis-à-vis the alternative structures, aiming for the same outcome. It is indicative of potential of savings by prudent choice of investing option & is as significant to ‘return on investment’ & ‘wealth creation’ as the investment selection & asset allocation are.

Income tax is a cost, directly attributable to an investment. This drag on return can be reduced by choosing a mode of investment that invites least income-tax incidence, while maximizing the return potential. It is the ‘post-tax-return’ that is relevant for the investor. A reduction in the income-tax cost, naturally improves the net rate of return for the investor & increases the pace of compounding of wealth creation.

  • Tax saving of Rs. 1 lakh each year over working life of 30 years equals ‘Total Savings’ of Rs. 30 lakhs.
  • If these annual savings earn CAGR of 10%, it transforms into additional wealth of Rs. 1.65 Cr.

Investment & Income Tax

Income-tax rules are often used to provide incentive for capital formation in certain areas of economy & hence certain savings are either exempted or treated to lesser income-tax burden. The incentives are implicit in the mode of investment & the rules relating to what constitutes taxable income.

Each investment goes through 3 stages – (1) Investment, (2) Earnings (capital appreciation / return paid out or reinvested) & (3) Maturity / Redemption / Withdrawal. The income-tax rules specify the method of calculation & the stages that are exposed to income-tax.

6 Variations in Tax Treatment

Three stages make for six possible ways in which an investment could be either be exempted (E) or taxed (T). The difference in tax treatment arises due to

  • classification of investment as an asset or loan,
  • revenue recognition rules &/or
  • need to channelize public savings towards certain instruments.

EEE – Exempt, Exempt, Exempt

  • Tax deductions at the time of investment,
  • Tax Exemption to income earned on investment &
  • No Tax at maturity / redemption stage.

Examples of such least taxation are –

  • Employee Provident Fund (EPF)Deduction under Sec 80C, Exemption of TDS on interest for contribution under Rs. 2.5 lakhs/5 lakhs, No tax on maturity
  • Public Provident Fund (PPF) – Deduction under Sec 80C, Exemption on interest for annual contribution under 5 lakhs, No tax on maturity
  • Sukanya Samriddhi YojanaDeduction under Sec 80C, Exemption on interest, No tax on maturity
  • Life Insurance Policy – Deduction under Sec 80C, Exemption on interest, No tax on maturity
  • Unit Linked Insurance Plan (ULIP) – Deduction under Sec 80C, Exemption on interest, No tax on maturity

EET – Exempt, Exempt, Tax

  • Tax deductions at the time of investment,
  • Tax Exemption to income earned on investment &
  • Tax Deferred till time of withdrawal.

Examples of such deferred taxation are –

  • Pension Plans incl. NPS, Unit Linked Pension Plan (ULPP) – Deduction under Sec 80C, Exemption on capital appreciation, Tax on annual pension received from non-commuted portion & on surrender value
  • Equity Linked Saving Scheme (ELSS) Deduction under Sec 80C, Exemption on capital appreciation, Tax on long term capital gain on units redeemed in excess of Rs. 1 lakh

ETE – Exempt, Tax, Exempt

  • Tax deductions at the time of investment,
  • Tax on income accrued/received on investment &
  • No Tax at maturity / redemption stage.

Examples are –

  • 5-Year Tax Saving Fixed Deposit – Deduction under Sec 80C, Tax on interest earned, No Tax on maturity
  • National Savings Certificate (NSC) – Deduction under Sec 80C incl. interest reinvested for first 4 years, Tax on interest earned, No Tax on maturity
  • Senior Citizen Savings Scheme – Deduction under Sec 80C, Tax on interest earned (interest up to Rs. 50,000 exempt under Sec 80TTB), No Tax on maturity

TEE – Tax, Exempt, Exempt

  • No Tax Deductions at the time of investment,
  • Tax Exemption on income earned on investment &
  • No Tax if held to maturity. 

Example is –

  • Tax Free Bond – No tax deduction on investment, Tax exemption on interest earned (interest rate payable is lower than prevalent market rate), No Tax if held to maturity (capital gain tax if sold earlier)

TET – Tax, Exempt, Tax

  • No Tax Deductions at the time of investment,
  • Tax Exemption on earnings on investment as long as not redeemed / matured &
  • Tax on earnings in year of redemption / maturity

Examples are –

  • Debt & Debt Oriented Hybrid Mutual Fund – Tax on Capital gain on units redeemed at marginal tax rate, if redeemed before 3 years & after 3 years @ 20% on capital gains after cost inflation indexation
  • Equity Shares & Equity Oriented Mutual Fund (Except ELSS) – Tax on Capital Gain on units redeemed @15%, if redeemed before 1 year & after 1 year @ 10% (in excess of Rs. 1 Lakh)
  • Fixed Maturity & Monthly Income Plan Mutual Fund

TTE – Tax, Tax, Exempt

  • No Tax Deductions at the time of investment,
  • Tax on earning &
  • No Tax on redemption / maturity

Examples of such maximum taxation are –

  • Fixed Deposit (FD) with Bank / Corporate – Accrued Interest taxed at marginal tax rate
  • Recurring Deposit (RD) – Accrued Interest taxed at marginal tax rate
  • Post Office Monthly Income Scheme – Accrued Interest taxed at marginal tax rate

Tax Planning through Mutual Funds

Tax Planning is analyzing a financial situation from tax perspective so that financial goals could be achieved with minimum tax burden. Mutual Funds are on top of the tax efficiency scale on account of its classification as a ‘Capital Asset’, favorable taxation rates, operative flexibility & liquidity.

  • The return on mutual fund investment is recognized as Capital Gain (as opposed to Revenue Income) & that makes the distinction between realized & unrealized return, quite significant from taxation perspective. Only the realized gain i.e., profit in respect of ‘investment-sold-during-the-year’, is taxed. Unrealized gain is just paper profit that is not required to be reported in the annual income tax return.
  • Taxation rules for a mutual fund remain unchanged even if the underlying investment is earning revenue income. Profit on sale of scheme earning interest on debt instruments, is still a capital gain & is amenable to postponement & reduction of tax on incomes that would otherwise be taxed at marginal tax rate. For example, interest income on FD, RD & loan is taxed at marginal tax rate (on accrual, not receipt basis) but the same income, housed in a mutual fund scheme, can remain untaxed till the time of sale of such scheme. Also, the said sale of mutual fund scheme can be spread over various financial years to reduce / spread income-tax burden.
  • No TDS (tax is deducted at source) is deducted on mutual funds except to NRI.
  • A mutual fund scheme itself, is not subjected to income tax because the said income belongs to the investors. However, the same realized gain would be taxed if the transactions were done in investor’s personal capacity. Thus, routing an investment through a mutual fund scheme helps avoid recurring tax cost on income that gets realized due to compulsions of portfolio management or expiry of individual investments. The obvious benefit is improvement in rate of return on investment.
  • Capital Gains are taxed more favorably as compared to other revenue incomes, by the government to promote economic activity in the country. Lower tax rate applicable to capital gains as well as concept of cost-inflation indexation, leads to significant reduction in tax burden.
  • Carry Forward & Set-Off rules for Capital Loss incurred during the year, also help reduce / plan income-tax outgo.
  • Investment in mutual funds is not charged to wealth tax.
  • Clubbing provisions of Sec 64 of Income Tax Act (income of minor & income on gift to spouse, daughter-in-law) can be overcome if investment is done via mutual fund. The flexibility of timing the sale & non-taxation on unrealized income enables better tax planning.

Tax Efficiency of Indexation

The Income Tax Department allows adjusting the cost of purchase for inflation at the time of sale of House Property & ‘Other than Equity Oriented Mutual Funds’ (after holding period of 2 & 3 years respectively). Adjusting the purchase price for inflation is called indexation & helps reduce the tax burden.

Indexed cost = (Index for the year of sale/ Index in the year of acquisition) x cost.

Cost Inflation Index
Sno.Financial YearCost Inflation Index

Illustration –

Purchase Cost = Rs. 1,00,000/- in financial year 2005-06,

Sale Value = Rs. 4,50,000/- in financial year 2022-23

(A) Without Indexation

Financial Capital Gain = 4,50,000 – 1,00,000 = Rs. 3,50,000/-

Income Tax @ 20% = Rs. 70,000/-

Post-Tax Capital Gain = 4,50,000 – 1,00,000 – 70,000 = Rs. 2,80,000/-

(B) With Indexation

Indexed Cost = (331/117)*1,00,000 = Rs. 2,82,906/-,

Taxable Capital Gain = 4,50,000 – 2,82,906 = Rs. 1,67,094/-

Income Tax @ 20% = Rs. 33,419/-

Post-Tax Capital Gain = 4,50,000 – 1,00,000 – 33,419 = Rs. 3,16,581/-

Tax Efficiency due to Indexation = 70,000 – 33,419 = Rs. 36,581/-

Superior Compounding

Debt Mutual Fund vs. Bank Fixed Deposit

Interest accrued on bank fixed deposit is taxed at marginal tax rate while the same income if routed through mutual fund instrument, could fall outside the tax net. The tax saved or rather not paid, remains part of the principal amount & earns return as well. The following years witnesses the return on ‘tax-not-paid’ continuing to earn ‘return-on-return’. As it happens with compounding, the benefits grow exponentially with passage of time.

Year    FIXED DEPOSIT @ 6% CAGR                  DEBT MF @ 6% CAGR

 Opening Balance (Rs)Return @ 6% p.a.Tax @ 30.90%Post Tax Return (Rs.)Closing Balance (Rs)Opening Balance (Rs)Return @ 6% p.a.Closing Balance (Rs)
 Total (Rs.) 56,052 225,347  320,714
Corpus accumulated after 20 years >>>FD = Rs. 2,25,347/-Debt Mutual Fund = Rs. 3,20,714/-
Excess Return (Debt MF over FD) on Rs. 1 lakh over 20 years (Rs.)95,366
Tax Efficiency at Highest Tax Bracket on Rs. 1 lakh over 20 years (Rs.)56,052

Asset Allocation

Financial history has been a witness to an investment yielding huge gains for individuals who bought & held it for a long-generation-long period as well as how these very assets have had a deep & painful drawdown*. It is often inferred from recent history – last 40 years of 200 plus financial years – that it is profitable to wait out the underperformance of stock market. Inferences are similarly drawn for other asset classes as well, on basis of what has transpired during last few decades.

(*Drawdown is % by which market value of asset drops from its previous high.)

However, a more holistic assessment of what has transpired during these 200 years, indicates that epochal changes have taken place in the past & will do so again in future. The inferences / assumptions of how investments pan out over a period of time, need to be taken with a pinch of salt given the following data points:

  • Stocks underperformed Bonds from 1929 to 1949 in USA. The investors lost 80% from top during this period & that would have needed 300% gain just to get even i.e., compounding of 6.41% (average US equity return) for 26 years. A 50% drawdown would need 11 years at same rate to break even. There have been 3 periods in last 75 years of US stock market when S&P 500 index took more than 10 years to go past its previous high point.
  • Bonds too have had deep drawdowns in the past – 60% in US & UK & 80% in France, Italy, Japan & Germany. Hyperinflation has destroyed value in other countries as well at different times in history.

The above exemplifies huge risk of investing in one security, country or asset class. An asset class (including Equity) can possibly go on underperforming other asset classes for a very long time & an investor may not have sufficient time to recover from the drawdown. Financial planning needs take such risks on board to avoid disastrous consequences.

Optimizing Risk-Reward ratio

Risk is the measure of uncertainty of achieving return as per investor expectation. It can assume different guises i.e.,

  • fluctuation in value of investment (due to market movements & changes in interest rate / exchange rate),
  • permanent loss of capital &
  • inflation (loss of purchasing power).

Risk-Return trade-off means that invested money can render higher profits only if the investor accepts a higher possibility of loss. While there is no perfect measure that encapsulates all risks of investing, volatility catches its essence well. Each asset class** has a certain risk profile & return expectation dynamic. Cash & fixed income provide known income streams. The low variation of returns (standard deviation) makes it a lower risk investment than property & shares, where a higher potential for return is accompanied by far more variation in the income streams & capital value over time.

Optimizing the risk-reward ratio of an investment portfolio means that returns are maximized by diversifying investment across a range of asset classes, regions, sectors & securities, while reducing overall risk of the portfolio. The objective is smoother returns over the long-term & a surer glide path to financial goals.

**Asset Class

It is a grouping of investments with exhibit similar risk-return dynamics & cash flows. Each such group performs differently in any given market environment thereby reflecting little or negative correlation with outcome of other classes. Equities, Fixed Income, Cash & Cash equivalents, Real Estate, Commodities & Currencies are the various asset classes to choose from at time of investment.  

What is Asset Allocation?

Asset Allocation is the strategy of – ‘optimizing the risk-reward ratio’ of the portfolio – by dividing the investments in a definite ratio – across various asset classes. The objective is to help navigate the uncertainty of the investment process & maximize risk-adjusted returns of portfolio in order to achieve financial goals with fair degree of certainty.

Impact of Asset Allocation on Portfolio Returns

Asset Allocation ensures that one takes the right amount of risk for the desired rate of return needed to achieve financial objectives. Risk – too much or too little – can derail a financial plan.

  • Variability of ‘returns across time’ – 90% of the movement of one’s portfolio from quarter to quarter is due to market movement of the asset classes in which the portfolio is invested. Bullish or bearish sentiments prevailing in the market for asset classes has an overwhelming influence on returns of total portfolio.
  • Variation of returns between Mutual funds / Pension funds 40% of it can be attributed to Asset Allocation Policy followed by the fund, while the rest 60% is explained by security selection, timing, & fee differences of these funds.

The impact of asset allocation on ‘portfolio returns’ depends on the investing style.

  • Long-term, Passive investor – Asset Allocation has a significant influence on ‘buy & hold’ investments. Given that it is mostly passive investment behavior that guides corpus accumulation for retirement, asset allocation decision has a ‘make or break’ effect on retiree.
  • Short-term / Trading investor – Frequent trading in individual securities &/or practicing market timing strategy hugely lessens the impact of asset allocation of portfolio on returns.

How to allocate?

An investment portfolio should be constructed in a way that it best reflects the investor’s

  • Return Expectationthat meets short-term, medium-term & long-term goals,
  • Time horizon of investments,
  • Assets & liabilities,
  • Risk Capacity – financial ability to bear volatility &/or loss,
  • Risk Tolerance – personality trait of how one reacts to adverse events &
  • Risk Appetite – combining capacity & tolerance to decide degree of risk that may be taken.

Why is Asset Allocation so crucial?

Asset Allocation policy strives for optimal risk for desired returns because mismanaged risk creates havoc with financial planning of the investor. Too much volatility can be as counter-productive to the cause as is the destruction of purchasing power on account of volatility-avoidance. Inflation is an investment risk. It destroys purchasing power & also influences setting of interest rates in the economy, the effect of which transmits through Debt, Equity, Real Estate, Gold, Commodity & Currency markets in varying ways. Thus, arises the need for diversifying investments among asset classes with little or negative correlation, to not only mitigate the loss of purchasing power by earning real return but also lessen the effect of drawdown of risky assets on total portfolio.

Given the historical performance of risky assets, it is easy in the hindsight to feel an investor can wait out the underperformance of an asset class but

  • it is a behavioral challenge for an investor when it is actually happening. 5 years is a short time in an investment cycle but can feel a lifetime for an individual.
  • An investor is either looking at a peak or a deep drawdown & attitude to risk changes with market cycles, driven by greed & fear. Bull market pushes investors to more buying & bear markets towards scaling back on investments. Recency bias makes sure of that.
  • The largest drawdown is likely to be in future as the corpus generally grows over time. A deep downturn will happen on a higher base & a higher damage as a result.
  • Price paid for risky asset is extremely important. Last 15 years have yielded lesser post-inflation equity returns than average real return of last 30 years because valuation (PE ratio) at which equity is available matters a great deal. The high starting valuations set the stage for poor returns in the following period. Once PE goes beyond a certain level, forecasted median returns become negative for following 10 years.
  • Gold has been a hedge against political, social uncertainty & inflation but is not a productive asset. The returns from this asset need to be conservatively assumed.

Asset Allocation brings a certain discipline to the investment process because investment decisions get driven by the policy of asset makeup of portfolio & not by market driven emotions. Portfolio should be rebalanced whenever market conditions push the weightage beyond an acceptable variation. Such discipline of investment process not only reduces portfolio volatility but also produces superior risk adjusted returns. 


Strategic Asset Allocation

It targets a fixed proportional combination of assets based on expected rates of return for each asset class. It is akin to a buy-and-hold strategy, with diversification to manage risk & improve returns. For example, if stocks have historically returned 12% p.a. & bonds have returned 6% p.a., a mix of 70% stocks & 30% bonds would be expected to return 10.2% per year.

Tactical Asset Allocation

It is a moderately active strategy wherein short-term, tactical deviations may be made to capitalize on exceptional investment opportunities. The market-timing seeks to participate in more favorable economic conditions for an asset class as compared to others. The overall strategic asset mix is returned to when desired short-term profits are achieved. The asset mix of portfolio should reflect the goals at any point in time.

Dynamic Asset Allocation

In this active asset allocation strategy, the mix of assets is constantly adjusted to reflect the changes in the investment environment. The changes made to asset allocation may be on the basis of portfolio manager’s judgment or a pre-determined investment framework. This strategy is polar opposite of strategic asset allocation.

Integrated Asset Allocation

While all the strategies mentioned above focus on expectations of future market returns, investor’s risk tolerance is not built into the framework. Integrated asset allocation strategy accounts include risk tolerance in deciding the asset mix whenever changes in the market environment demand an adjustment.

Risk Parity Allocation

Ray Dalio advocates concept of ‘Risk Parity’ that constructs a portfolio based on risk of the asset class. Most portfolios have a very strong bias to do well in good times & bad in bad times. A 60/40 stock/bond portfolio does not have ‘60% of overall risk’ weighted to stocks, rather 90% because equity is 3 times more volatile than bonds thereby dominating overall total volatility. He observes that every investment has an ideal environment in which it flourishes i.e., there is a season for each kind of investment.

There are 4 types of investment environment created by how growth & inflation measure up against market expectation. The type of environment that gets created by confluence of these economic forces, provides the conditions for certain asset classes to flourish & the rest of asset classes to languish. How growth & inflation measure up against market expectation, creates an economic environment that provides perfect conditions for certain asset classes to give better returns –

  • Higher Inflation – Commodities, Gold, Inflation linked Bonds
  • Lesser Inflation – Stocks, Treasury Bonds
  • More Growth – Stocks, Corporate Bond, Commodities, Gold
  • Less Growth – Treasury Bonds, Inflation linked Bonds

He therefore advocates to have 25% of risk in each of these four categories – not 25% of wealth in each category. That is because nobody really knows which of 4 seasons will come next. With this approach, each season is covered all the time, so you’re always protected.

Are you feeling it?!?

Mukesh Ambani calls an emergency family meet at the terrace of his home, to discuss the havoc inflation was causing to family finances. Ten minutes past the scheduled time & no sign yet of Nita Ambani! It was to a cold reception that she finally arrived. Really, was she to blame if the other 4 family members beat her to the 4 home lifts. The damned lift was no bullet train & with 27 floors down & then up – the late arrival was inevitable to say the least.  

No! this is no reality programme on Ambani family. Rather, it was a dream that I had last night!!! I am not sure if the Ambani clan has ever been to their home terrace but imagining Ambani(s) scurrying around, worrying about inflation, does seem a bit funny. Can you imagine any of the top 10% rich, breaking a sweat now that world is experiencing 4-decade high inflation?!? No, luxury goods will continue to sell well even as line for free food keeps getting longer. It is different point in time for everybody when the pinch begins to be felt.

Well! Are you feeling it yet?!?

The importance of understanding the various dimensions of this phenomenon cannot be overstated. Be assured, you would be thinking a lot on this topic over near future, even if not already doing so.

(*** Brief detail on various aspects of inflation follows this article.)

Unequal Impact of Inflation

The effect of inflation – loss of purchasing power – is common to each one of us but its impact is very much unequal. Differences in spending pattern & varying degree of inflation in different goods & services – lead to unequal levels of inflation for different households. Inflation inequality is the unequal effect of inflation on middle, upper-class people & lower-class people.

Cost of living increase can be attributed to the nature of composition of consumption basket. It could be

  • health care expenditures for the elderly,
  • food & gasoline prices for the poor households,
  • education & health care for the middle class.

The disparity in impact of inflation on different sections of economy cause the income gaps between rich & poor to widen. The main reason of the unequal impact lies in the type of work that generates income, which in turn determines the time-lag & degree to which inflation gets adjusted to a person’s revenue source.

  • Lower-income people have much less negotiating power because of power imbalance. When prices rise, wage for such individuals tends to stay stagnant for a while. As a result, their purchasing power plummets.
  • Goods & services with administered prices, are only able to pass on price increase to the consumer, with a certain time lag such as agricultural produce etc.
  • Better quality job people tend to have inflation-adjusted benefits. When inflation occurs, these benefits mitigate the negative inflationary impact.
  • Businesses tend to pass on inflationary impact to its customers in real time & if it finds itself unable to do so, reduces its size/cost to remain profitable.
  • Equity investment income is a proxy of businesses in formal sector & of certain scale. Business profits have to keep pace with inflation to remain viable & such growth in profits gets reflected in better valuation of equity shares. Thus, money invested in equity shares maintains / improves its purchasing power.

Inflation Data

Check out the inflation data over last 10 years. The average cost of basket of goods has increased 67% by government estimates & must actually be much higher at household level. Effectively, by year 2032, you would need double the money you have now, just to maintain your living standards – assuming – your consumption basket & inflation rates remain same.

Please note that need for income (plus savings – which is postponed consumption) is going to be even steeper because

  • Both assumptions are totally unrealistic. Just reflect on how much the basics of living have changed in last ten years. The changes will come even faster in future. Secondly, inflation in a growing economy is a given. Expect even higher rates, just so that you are not blind-sided if it so happens.
  • Downside of not maintaining purchasing power, is reduced living standards.   

All India Inflation rates (on Point-to-Point basis – current month over same month of last year – March 2022 over March 2021), based on General Indices & CFPIs (Consumer Food Price Index) are given as follows:

All India Inflation rates (%) based on CPI (General) & CFPI
IndicesMarch 2022 (Prov.)
CPI (General)                                         6.95%
CFPI                                                         7.68%
All India Consumer Price Index – March 2022 Index (Prov.) (Base: 2012=100)
Main HeadCombined (Rural & Urban)
Food & Beverages                                                            168.4
Cereals and products                                                        151.2
Meat and fish                                                                    210.7
Egg                                                                                    167.8
Milk and products                                                           162.2
Oils and fats                                                                    194.7
Fruits                                                                                 157.6
Vegetables                                                                      166.9
Pulses and products                                                          163.9
Sugar and Confectionery                                                   118.8
Spices                                                                                174.2
Non-alcoholic beverages                                                  177.4
Prepared meals, snacks, sweets etc.                                   179.3
Pan, tobacco & intoxicants                                         193.7
Clothing & footwear171.1
Clothing 172.1
Footwear   164.6
Housing 165.3
Fuel and light                                                                     167.2
Miscellaneous     164.6
Household goods and services162.8
Transport and communication157.9
Recreation and amusement163.3
Personal care and effects                                                      167.2
General Index (All Groups)                                              167.7
Consumer Food Price (CFPI)                                166.9

***Brief Explanation


Inflation is a broad measure of increase in prices or cost of living over a given period of time.

  • The absolute value of a currency note, say Rs. 100/-, remains constant over time.
  • When prices of goods & services increase, household income (received in such constant value) can afford to purchase less.  In other words, purchasing power of income falls.
  • Real income (inflation-adjusted income) is a proxy for the standard of living. When real incomes rise, standard of living is deemed to improve.

Measuring Inflation

At Individual Level The cost of living depends on prices of goods & services consumed & the share of each in the household budget. The change in cost of living is inflation for the household, assuming living standard remains same. The average calculated for total population (rural, urban or consolidated), may differ from inflation of a household’s basket.

At Consumer Level – The average consumer’s cost of living is measured by household surveys that identify a basket of commonly purchased items & tracking over time the cost of purchasing such basket. The measure is called Consumer Price Index (CPI) that expresses cost of this basket at a given time relative to a base year.

Core Consumer Inflation – It identifies underlying & persistent trends in inflation by excluding prices set by the government & which are affected by seasonal factors.

At Country Level – The index at country level has broader coverage & the calculation includes GDP deflator. The contents of GDP deflator are more current, including non-consumer items (such as military spending) & vary each year (CPI basket is mostly fixed). It is not a good measure of the cost of living, as such.

What Creates Inflation

Money Supply – Quantity theory of money explains inflation in terms of relationship between money supply & size of economy. Inherent value of currency will decline if money supply grows faster than the size of economy.

Cost Push – Increase in cost of items with inelastic demand such as fuel & food, transmits cost-push inflation through the entire system by trade. Impetus for price increase may come from supply side i.e., disruption in supply chain of inputs. Such disruption may be due to

  • natural disasters or
  • man-made crisis such as war, cartel pricing etc.

Demand Pull – Impetus of price increase may also come from creation of extra demand (GDP growth) vis-à-vis production capacity of an economy, by

  • decrease in interest rate by central banks,
  • increase in government spending (increase fiscal deficit),
  • stock market rally (wealth effect)

Expectation of Inflation – Expecting price increase in future causes ‘next-period inflation’. Such expectation finds reflection in – consumer buying more than requirement, wage negotiations, contractual price adjustments, automatic rent increase etc. Since human behavior is guided by recent experience, the pattern of ‘expectation causing next-period-inflation’ forms a loop & continues for some time.

Cost of Inflation

Erosion of Real Income – Prices in the economy change at different paces. Regularly traded commodities get priced immediately while other factors in economy get adjusted at periodical intervals such as wages. This uneven change causes loss of purchasing power for those with less negotiating power.

Fixed Interest Rates – Purchasing power of fixed interest rate products changes for the receiver as well as payer. If such fixed interest rate on debt is less than inflation rate then

  • purchasing power of payer improves, provided his income maintains pace with inflation.
  • real income of lender suffers.
  • purchasing power of person dependent on fixed interest income (say, a retiree) continuously declines.

Less Valuable Currency Countries facing hyper-inflation or high inflation rates have to devalue their currency & are faced with increased transactional costs.

Central Bankers & Inflation Targeting

Central Bankers have a love-hate relationship with inflation. Consumer behavior, types of goods & services produced, strength of currency, foreign trade & GDP growth rate are all deeply intertwined with inflationary trends in the economy.  Central bankers recognize the critical role of inflation in orderly conduct of economy & therefore target an inflation rate, that can balance the demands of various constituents.

Low, Stable, & Predictable inflation is good for an economy. The distortionary impact of inflation is reduced if it is low & predictable, as that causes least volatility in the economic environment. A steady pace of price increase gives consumers an incentive to make purchase sooner boosting economic activity, producers are more confident planning for growth & interest rates do not regular tweaking. Uncertainty on any account adds risk premium to the mix.

Deflation, or falling prices, is not desirable because when prices are falling, consumers delay making purchases, anticipating lower prices in the future. That sets off a chain reaction of less economic activity, less income generation by producers & lower economic growth for economy as a whole.

Central Banker’s Policy Arsenal include

  • interest rate at which debt flows in the economy,
  • administrative price setting of goods & services &
  • fixing exchange rate of currency.

The aim is to guide household & production decisions in the desired direction of either contracting or expanding the aggregate demand in the economy, managing inflationary expectations & providing predictable environment for long term contracts.  

How do Inflation & Investment influence each other?

Macro Level Inflation rate is a key input in determination of interest rates & money supply. Higher interest rates mitigate the loss of purchasing power due to inflation but would adversely impact capital investment & productive capacity in the economy. The economic policies have to carefully navigate through ‘interest rate-demand’ maze because controlling inflation & protecting economic growth require opposing policy interventions.

Household Level Loss of purchasing power due to inflation & the rate at which happens, has significant bearing on spending, saving & investment decisions.

Fixed Return Investment –

  • Held to Maturity returns – Real returns would be net of inflation. Bank FD are giving negative returns at the moment with interest rate significantly less than inflation rate.
  • Marked to Market returns – Price of fixed income security is inversely related to interest rate. In high inflation scenario, when interest rate is increased, market price of security will fall. Longer the duration till maturity, greater will be the negative impact on price of security when interest rates rise.  

Equity Investment The relationship between inflation & equity investment performance, is less definite. It would build in the influence of other factors such as

  • Products with inelastic demand benefit as inflation is passed on to consumer & become more attractive in the investment basket.
  • High & persistent inflation reduce aggregate demand if incomes fail to catch up & if real incomes do not decline, consumers save more & postpone buying decisions on account of uncertain future. Also, increase in interest rate feeds into higher production cost loop, impacting profitability in process.
  • Equity prices may initially get a boost with increase in profits when inflation gets passed on to consumer but get negatively impacted when growth prospects start getting shaky.

Real EstateCurrency loses its value (purchasing power) with inflation. In high inflation scenario, where confidence in financial asset is shaken, physical assets could prove to be good hedge against inflation & be preferable as an investment. Real estate investment trusts (REITs) can provide access to real estate investments with reasonable ticket size, with possibility of interest & dividends as regular distributions.

Commodities Gold has proven to be good hedge in times of high inflation & uncertainty. Exchange Traded Funds (ETFs) & sovereign gold bonds (annual coupon + capital gain/loss) provide an easy access for retail investors to include this asset class in portfolio.

How to hedge Investment against Inflation?

Hedging investment against inflation implies protection against ill-effects of inflation. Key factors that help maintain purchasing power of investment are

  • Backing of real (physical) assets such as Gold ETF, REIT etc.
  • Inelastic demand of product sold by business
  • Under-valuation of equity after taking into account challenges on profitability & growth
  • Equity of business enjoying leadership position, competitive advantage & better technology, human resources & management.

Compounding in Real Life

Would you care to guess?

  • How much do savings of Rs. 10,000/- per month &/or weekly expenses of Rs. 500/-, affect your wealth creation over your working life (say 30 years)?
  • How deeply is your post-retirement life shaped by wealth that you create in early stages of working life?

Ever wonder?

  • Why don’t people with same financial resources & opportunities, end up with same wealth outcome?
  • Why do certain people get rich while others don’t?

Luck may have a little bit to do with all above, being at a right place at the right time too but that is only a little bit. It certainly has a lot to do with what Einstein called the eighth wonder of the world – the compounding concept.

Compounding is the process of generating income on an asset’s reinvested earnings.

  • Simple interest is applied only to the principal & not any accumulated interest.
  • Compound interest is interest accruing on the principal & previously applied interest.
  • The effect of compound interest depends on how frequently it is applied.

It represents an investment’s progress over period of investment, assuming return is re-invested each year in the scenario of volatile annual growth. Compounded Return takes into account both rate of return & time for which money remains invested. The compound interest formula is: 

A = P (1 + r/n)nt

A = Future value of your investment,

P = Principal (the amount of money you start with); 

R = Annual nominal interest rate before compounding; 

T = Time (in years) &

N = Number of compounding periods in each year (365 for daily, 12 for monthly, etc.)

COMPOUNDING  @  12%  per  annum
YearYear Opening Balance (Rs.)Yearly Return (Rs.)Total Compounded Return (Rs.)Compounding Effect (Rs.)Closing Balance (Rs.)
(A)(B)(C=B*12%)(D = FV-PV)(D – 12*A)(FV)

In the illustration above, compounding @12% p.a. on investment of Rs. 100/-, return in in fifth year Rs. 18.88 & in the 10th year is Rs. 33.27. In the 5-year subsequent gaps, return for that year goes up to 58.64, 103.35, 182.14, 321.00 & so on.

  • The yearly return is not increasing at constant rate but exponentially &
  • Exponential growth is due to the fact that pile of return on ‘total return of previous periods’, keeps getting bigger with passage of time. As a result, return in each time period grows at a faster pace than previous period, driving rate of growth of return in ever-increasing spiral.

Rule of 69 Rule of 69 is an estimation of amount of time required for an investment to double, assuming continuously compounded interest.

T = [(69 / R) + 0.35]

T = Number of Periods required to double an investment’s value

R = Continuously Compounded Interest Rate per period, as a percentage

To estimate the time, in which a bank FD @ 5.25% p.a. of Rs. 1 lakh will increase in value to Rs. 2 lakhs >>> T = [(69 / 5.25) + 0.35] = 13.49 years.

Compounding has a lifelong impact

Positive impact – Every additional rupee saved & invested, every rupee in tax saved / postponed on account of tax planning – makes us wealthier due to additional return on returns already earned. Improving rate of return on investment, directly contributes to the pace at which compounding happens.

Negative impact – Compounding is a mathematical phenomenon & works on costs just as it does on returns. Unsustainable costs destroy wealth & negative impact of such cost too accumulates at exponential rate, with passage of time. The effect on wealth is

  • visible in cash costs such as interest payable on debt, 
  • camouflaged in hidden costs such as loss of purchasing power (due to inflation
  • hidden in plain sight in cases when legitimate means to reduce expense & tax outgo are not adopted, leading to loss of opportunity for higher savings.  

Periodicity of compounding – Effective Annual Rate (EAR) is critically relevant factor in bank financing options & loans. It signifies the effective annual interest rate on debt after taking into account, number of times interest cost is compounded during the year. Most common applications are in overdraft & home loans. For example, interest on overdraft account is debited each month.

  • An OD interest rate (12%) that you think that you are paying is actually 12.68%.
  • On an overdraft of Rs. 100, it is an additional Rs. 0.68 in first year but accumulates to extra Rs. 598.97 over 30 years.

Compounding in Real Life

  • Alternate investment proposals Investment proposals with dissimilar principal amount & time horizon are compared on common factor of Compounded Annual Growth Rate (CAGR).
  • Credit Card Debt While a case can be made for incurring debt to create productive asset, incurring debt to maintain lifestyle compounds the negatives of higher interest rate & reduced savings for investment.
  • Investment Gap ‘Additional Savings’ required in the time left for financial goal, to bridge the deficit between the financial goal & corpus accumulated thus far, can be calculated using the compounded return formula.
COMPOUNDING  @  12%  per  annum
PrincipalFuture Value (Rs.)Accumulated Return (Rs.)Period of investment (Years)Additional Time Taken (Rs.)
  • Transformative Power of Compounding It is a significant stage in personal finances when ‘accumulated returns’ starts adding as much gains as ‘principal investment’ would. Beyond such stage, trajectory of wealth accumulation becomes steep. In the illustration above, wealth becomes 2X of the principal amount in 6.12 years & 3X by 9.69 years but it needs just another 6.13 years to become 6X. In other words, time needed to progressively increase wealth – by an amount that is equal to original investment – reduces at exponential rate.
  • Cost of Delay in Investing – It reflects the loss of value on account of time. Time is more important to the outcome of an investment than the rate of return because an investor has some control over time to be given to an investment, unlike rate of return that is dependent on investing environment. Any reduction in one of the two factors – rate of return & time – necessarily increases the need for other. Procrastination is a common human failing, therefore shortening the time span of investment translates into higher need for savings to achieve financial goal. In case of financial goal with undefined time horizon, cost of delay is loss of opportunity to create additional wealth. Cost of delay is the leakage of value.
  • Latte FactorDavid Bach emphasized the importance of repetitive discretionary expenses however small, in wealth creation outcome over a period of time. It draws attention to expenses done as a matter of habit but which are unnecessary or do not provide commensurate satisfaction/happiness. These could be coffee, beer, subscriptions, weekend parties etc. He pointed out that isolated small value wasteful expenditures, if combined, are a source of additional investment & great potential value. The value of course, is embedded in exponential power of compounding & time value.   
ParticularsReferenceInvestor AInvestor B
Annual Rate of Return 12%8%
Period (years) 3020
Annual Investment (Rs.) 120,000120,000
Total Investment                                                                                       (i)3,600,0002,400,000
Total Value at end of period (Rs.)                                                                (ii)28,959,9225,491,436
Growth                                                                                  (ii -i)                (iii)25,359,9223,091,436
Cost of Procrastination & Inferior Return (Investor B)     (iii A – iii B)  (iv)22,268,486
 Discretionary & Avoidable Weekly Expense (Rs.) 5000
Reduction in Cash Outgo over 30 Years (Rs.)    (500*52*30)                         (v)780,0000
Future Value of Discretionary Expenses @ 12% p.a. (Rs.)                 (vi)7,697,8540
Loss of Opportunity for Investor B (Rs.)                    (vii)7,697,854
DOUBLE   FAULT    <<< >>>     Saving less & Spending more
Total Savings Invested (Rs.)                                    (i + v)                           (viii)4,380,0002,400,000
Total Wealth Creation (Rs.)                                       (ii + vi)                         (ix)36,657,7775,491,436
Extra Wealth Creation by Investor A (Rs.)              (ix A – ix B)                 (x)31,166,341 
Cost of Poor Investment Choices by Investor B (iv B + vii B)                 (xi) 29,966,341

Playing the Long Game

Most people play the short game of going for the most visible & immediate benefit. Anything that is hard is put off for another day. However, it is important to invest in success every single day. The daily effort yields tiny advantages that accumulate & over time become a foundation for more & better results. This is the long game that compounds rewards in life.

Every decision in life is a move towards either short or long game. Time amplifies whatever good or bad that comes of these decisions. Such an understanding can be applied to all things that matter in life.

Compound Knowledge – to fast track your progress in profession / business by contributing more value in least time.

Compound Relationships – to love & feel loved, to enrich life of people around you, to lead a happy & balanced life.

Compound Financial Returns – to create wealth & achieve financial freedom

Tracking Progress to Freedom

Financial freedom is the freedom to be who you are & to do what you want in life, without being limited by monetary considerations.

A plan for financial freedom projects

  • Minimum Corpus that would make it possible for one to live the desired lifestyle without the compulsion of having to work for a living &
  • Minimum Savings that could accumulate into the desired wealth size – subject to assumed post-tax return on investment of such savings.

Assumptions have to be made for such long-term projections

  • Inflation before & after retirement
  • Overall after-tax portfolio return
  • Life Span
  • Retirement Age (***age at which no compulsion for earned income)

Both these projections are far into future. A Danish politician once said “It is difficult to make predictions, especially about the future.” The remark may have been a tongue-in-cheek one but it does highlight the peril of making financial projections in a dynamic & complex environment, more so when assumptions have to be made for all the knowable & unknowable variables in the mix. A financial projection is only as good as the quality of data & the underlying assumptions. The challenge is even greater if time period under consideration is long as then the impact of each error gets amplified.

It is a very risky bet indeed to live one’s post-retirement life on the trust of a single figure that has emerged from financial projections. Before one draws a line in sand of time to indicate the inflection point of financial freedom, it is important to monitor progress towards this goal. One can opt for retirement only when ‘earned income’ ceases to be the primary reason to remain in employment / business.

Tracking the Progress

Focus of portfolio review has to be on the worth of corpus being accumulated. Corpus value would provide the answer to

  • if retired – for how long would the funds bear lifestyle expenses (inflation adjusted)? 
  • if working – how soon can one retire?

Formula to calculate the years

NPER(real return,-income,current corpus,,1)


  1. Real Return = (1+ return)/(1+inflation)-1
  2. return refers to post-tax return
  • Income refers to the amount required to manage expenses in the first year i.e., current expenses that will persist. The negative sign before income is to represent withdrawals.
  • This amount will be withdrawn each year from the corpus. Withdrawals each year will increase at the rate of inflation assumed in the real return calculation.
  • Balance corpus (after withdrawal) will grow at the rate of return assumed in the real return calculation.
  • Input between the two commas refers to targeted legacy amount. This is optional. If left empty, it is assumed the yearly withdrawals will reduce the corpus to zero.  If you set some value here, the yearly withdrawals will reduce the corpus to that value.
  • Current Corpus refers to the accumulated retirement fund.
  • The “1” refers to the withdrawals made at the start of the year.


NPER is a simple measure to appreciate ‘where we are’ in our journey to financial freedom, given the underlying assumptions.

Market returns are non-linear.

Asset Allocation undergoes a change with a change in risk tolerance, which directly impacts return (key input in the formula). It is a long period that is under consideration – before & after ‘earned income’. Each of the assumption has to be appropriately adjusted with a change in long term trend of inputs or with change in circumstances related to lifestyle.   

You won’t get wealthy, unless…

Wealth Creation is no rocket science. It is possible for anybody & everybody – irrespective of how little resources one is starting out with. Wealth gets created by consistent application of few proven financial processes over a length of time. It is time-tested certainty. Of course, for creating the kind of wealth that gets one into exclusive club of super-rich, these financial processes need the acceleration of financial, knowledge, time, network & technology leverage.

Wealth is a natural by-product of spending less than one’s earning, investing the savings as per time tested principles & letting returns compound over time. Yet, very few succeed at what is simple, achievable & sought after. The question is

  • why is it that so few actually manage to become wealthy?
  • what is it that prevents more people from realising a goal, the plan of action of which is public knowledge?

This ‘hiding in the plain sight’ puzzle suggests that wealth & financial freedom would remain an unattainable dream, unless the core reasons of such mass failure are addressed.

The abysmally low success rate of wealth creation is not without reason.

Desire for wealth is somehow, not getting followed up by action necessary to fulfil it. The disconnect occurs because of the direct conflict between requirement of ‘persistence over time’ for wealth creation & ‘human desire for instant gratification’. It makes following up on these simple rules, a much tougher ask. The only solution to this conundrum is to purposefully align these opposing tendencies by a more deliberate & thoughtful approach to life.

The irony of wealth is that everybody considers it to be important but very few deem it so urgent that it be prioritized above all else. The default mode is short-term thinking, preferring immediate pleasures of consumption over long term desirability of wealth. As long-term vision will not happen on its own, one has to proactively balance long-term needs with the urgent day-to-day ones. Once long-term financial health is prioritized over everything else, the patterns of spending, saving & investment change to fit the altered framework. The solution is to emphasize important, long-term goal in each of the numerous daily decisions that have to be made. So much so that long term thinking becomes a habit.

How to solve the problem of short-term thinking?

Long-term thinking can be inculcated by a deliberate, habitual process of making a financial choice. Focus should be on impact of the financial decision over next 20-30 years & on the fact that long-term effect of poor financial decisions is poverty. Once long-term approach becomes a default response, then each act of saving would generate sense of satisfaction at building wealth rather than the negativity that accompanies when consumption is sacrificed. The solution lies in making long-term thinking desirable by a change of perspective & priorities so that a person’s short-term actions no longer hinder wealth creation.

Why is the change in perspective going to be such a hard work?

Avoiding pain provides greater motivation to act than pleasure. Wealth creation is a (unknown, & long into future) pleasure goal that demands sacrifices (known & in short term). The pleasure pull of wealth creation is weak & postponement of the process too does not cause any pain. One merrily carries on with status-quo until it is too late to recover. All wealth creation knowledge is a call for action only if one realizes that status-quo has pain waiting in future. Otherwise, it is just shouting at the deaf. The solution to wealth creation is to remain highly motivated towards it. Motivation for wealth comes only when the pain of impending financial insecurity is felt even more intensely than the pain of foregone consumption (savings).

How to stay motivated for wealth creation?

One would want to save if focus is on potential of wealth, rather than on foregoing consumption, just as a smoker will quit only if he acknowledges long-term health damage more than satisfaction of smoking. Not-saving is the smoking away of one’s financial health. If the focus shifts to obvious benefits of short-term regular actions (saving) & their long-term context (compounding of returns), the inconvenience turns into desire. There would then be no need for forcing discipline on oneself as one would only be doing what the heart wants. The solution is in loving the result of one’s action rather than action itself.

You are already in 1 of these 3 scenarios. Which one?

Each day in every financial or non-financial decision, one either moves towards wealth or away from it. The decision making could be deliberate or as per habit hard-wired into the brain.

No priority to wealth & financial security – You are doing nothing now & most likely would not be able to much in future because what is difficult now will get even more out of reach, as time window starts closing. The likely outcome is that of dependency on others – who may or may not love you. Either way, you are putting yourself in line of fire.

Realize the need but not started yet – You are either complacent or are unable to figure out the way to squeeze out savings & start investing. Procrastination is wealth suicide in instalments. As years pass on, you miss out on juicy part of wealth creation i.e., compounding of returns. You are then forced into chasing higher return to make up for lost time & make tougher choices – choices involving higher risk & lesser assurance of outcome.

Postponing the gratification – You pay out to your future self by foregoing current consumption so as to be financially independent. The sacrifice slowly turns into satisfaction, as you see your wealth grow. As efforts at wealth creation get validated, future looks more promising & you find joy in continuing the habits that are paying dividends. The growing wealth not only presents potential for much more, it also gives you satisfaction at having acted responsibly.   

There are 3 possible life scenarios & every person is already living 1 of the 3. A quick status check will reveal the future that you are headed towards. Do a course correction, if you feel that outcome of current habits is not matching up to vision that you have for yourself.

Contentment of Financial Freedom

Financial Freedom is being in control of one’s finances & life choices. It is not a one-size-fits-all outcome for every investor but could mean something different to every investor. Financial intelligence is no doubt, a primary condition for wealth creation because desperate choices (lifestyle that cannot be afforded) or imprudent ones (investment designed to erode wealth), lead straight to financial burden – an imprisonment of circumstantial kind. Even so, financial freedom is as much about generating wealth as it is about understanding one’s motivation for seeking such wealth (not-needing-to-work / ability to pursue a passion / owning house & car / living a debt-free-life-of-leisure / ability to fund charities etc.).

The motivation provides purpose to the strategizing & calculations, while pursuing this ultimate goal. However, achieving financial freedom & zeroing in on purpose of this freedom, is easier said than done.

  • Firstly, wealth creation is extremely difficult goal to achieve despite being conceptually very easy. It needs regular savings over long period of time, besides good investment practices. Most people tend to get lost in the process itself.
  • Secondly, our consumeristic-culture encourages material gratification as a marker of success & happiness. Placing limits on one’s gratification &/or postponing it (so as to invest), is a huge behavioral challenge.

Wealth is a powerful incentive but undefined nature of pursuit of wealth is only a whimsical endeavor. It does not tell you when to stop or that it is indeed possible to stop. Success gets defined by more & more, no matter if such ‘more’ loses all meaning along the way. Mr. Bogle, the founder of Vanguard, illustrates this phenomenon in his book “At a party given by a billionaire on Shelter Island, Kurt Vonnegut informs his pal, Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel ‘Catch-22’ over its whole history. “Heller responds, ‘Yes, but I have something that he will never have … enough.’”

A 2021 study by Matthew Kllingsworth for the National Academy of Sciences has found that happiness & money aren’t as closely linked as we assume. “If income is below $75,000, more money allows for more happiness in that it allows greater access to basic necessities, improving overall quality of life. But any increase above that $75,000 doesn’t really affect happiness in a concrete way.”

If financial freedom is to be defined & achieved, then it cannot happen without knowing what is contentment all about. Contentment embodies freedom to be who you are, enjoy who you are, & live the life you were destined to live. It also reduces stress level, improves one’s outlook, relaxes the body & makes life enjoyable. Breaking the cycle of wanting more & being satisfied with one’s current possessions, status & life, is key intentional effort to becoming content. The simple discipline is to be grateful for good things one has, instead of focusing on what is missing.

Have you ever wondered why discontentment returns soon after upgrading or buying a new product? It is because material possessions can never fully satisfy the desires of heart. Solution to discontentment is not in acquiring that missing thing but lies within one’s personality – in knowing why is the missing thing at all causing unhappiness?  Also, it helps to become a content person if one does not compare oneself with others because we always compare the worst of ourselves to the best assumptions we make about others. Nobody’s life is perfect & everybody is unique in one’s own way. The proactive way to contentment is in helping others, sharing your talents, time & money as that gives finer appreciation of what one owns & what all can one offer to others.

If you don’t move the goal posts – don’t need a bigger house, a nicer car or a more elaborate vacation or gets tempted by every new shiny material thing that comes along – then you could claim the ultimate prize of financial freedom by accumulating wealth sufficient to support a lifestyle, reflective of one’s core self over the lifespan & ensuring that investments are so managed that they stay ahead of inflation.

There can be no financial freedom without contentment because ‘targeted financial corpus’ is a goal post that will move further away with every new desire. Contentment may be a personality trait for some but for others, is definitely achievable with intentional effort.

Good, until it is not

Faith is the firm conviction that things would pan out, as they are supposed to. It is the confidence in the outcome despite an unknowable environment. However, faith alone without the backup of preparation & effort, can be a recipe of disaster. Investors are by nature an optimistic lot & are prone to putting excessive faith on financial projections, historical patterns, efficiency of markets & guidance by central banks.

The combined impact of excessive reliance on accepted truths, herding behavior (following the actions of others rather than personal belief) & recency bias (chasing the latest fad) can be such that market distortions thus created, could continue for a significantly long time before getting corrected. The economic logic may be managed by powers that be but it certainly cannot be denied. A free lunch is not be had!

Default Assumption of Investors

Investors & advisors depend on certain assumptions to decide on their strategic asset allocation, build portfolios & establish expectations for risks & returns. Overtime, megatrends (trends that occur on global or large scale) have the effect of imprinting such assumptions in the minds of investor community as default condition, instead of a variable that would change with changing economic, social or political environment. It becomes a heuristic (mental short cut to investment decisions) & is no longer subjected to intense scrutiny.

When market trends make you wonder if economic logic no longer applies then maybe it is time to revisit the assumptions.

  • Interest rates in all power house economies have been low for better part of last 40 years (were even negative for some time) on back of low inflation economic set up – hence the market assumption that interest rates cannot rise, much less shoot up!
  • Equity valuations the world over, are at all-time high despite the pandemic, low expected growth in world GDP & increasing political tensions – on assumption of near zero% interest rates for foreseeable future, equity valuations have only one way to go i.e., UP!
  • Real Estate market constitutes a significant portion of developed economies & is strong even beyond the scale last seen at the time of 2008 crisis – on assumption of low interest rates to continue, 2008 is not expected to repeat.
  • Crypto-currencies continue to attract large funds, when it does not create any value or cash flow & facilitates illegal fund transfer – on assumption that it could replace fiat currency when governments give up their very source of power.
  • Central Banks continue to expand their balance sheet by printing money on expectation that inflation will continue to remain in check. Markets expect central banks to come to rescue of markets, in case of another crisis – on assumption that they have not already exhausted all their options to manage ever increasing size of a crisis that follows the previous one!

Anyone born in last four decades would have experienced the current economic environment of low inflation, high GDP growth & increasing valuations (despite short term hiccups) & would not know other possible economic possibilities. In fact, investors & policy makers seem to believe that world has permanently moved beyond the possibilities of war, high inflation, stagflation, low growth rates & political instability. It would be prudent though, to consider long term historical data.

  • US 10-Year Bond Yield remained in a band of 1.5% to 3.5% from 1913 onwards till it increased to 5.1% in 1979 & had shot up to 15.7% by 1981. Following that peak, interest rates have been kept down to the extent that real interest rate yield are negative.
  • It had taken just 8 years (1973 – 1981) of high inflation (8.5% to 12.5%) to yank interest rates from 3% range to 15%.
  • S&P 500 Index gave 0% return from 1929 to 1956 (27 years), from 1968 to 1987 (19 years), from 2000 to 2015 (15 years) & since then has moved up from 2450.47 to 4766.18 as at 2021 end.

For it is good, until it is not.

Nassim Nicholas Taleb once said “Most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk.”

To those who are betting their economic future on interest rates remaining forever low, inflation always in check and equity (& crypto) being valued as per the Greater Fool Method’, it would be do well to remember that

  • Markets have been so pushed to such an extreme by adventurous policy making that if one or more pieces of the above jigsaw puzzle come off then things could unravel very fast. The trigger could be anything – maybe not even economic or health concern.
  • When next financial crisis occurs, if central bankers don’t come / cannot come / come but are ineffective then value destruction across all asset classes would be huge.
  • Equity valuations rise inevitably after every fall & after a short period, is a mistaken notion. As historical data suggests, investors need to be prepared for a lost decade or two.
  • Pension Funds & retirees dependent on bonds, investing in negative interest yields are actively looking at a crisis-in-the-making.
  • There are already some 8000 types of crypto-currencies. Even if crypto survives the regulatory challenges, for these essentially bet against official currency & find some application, only the ones that remain in fray will have value. The rest will go bust.

The idea is not be an alarmist but to remain open to possibilities that the scene could change & in a big way. If that were to happen one should not have been pushed oneself into a corner & left no space to maneuver.

Asset Allocation, goal-based approach & re-balancing should help traverse the tricky period that seems ahead.

House Property – Rent or Buy

Real Estate, unlike other investments, is not evaluated on parameters of liquidity, safety, pricing & returns alone. All decision factors for real estate purchase – finance, investment time span & emotional connect – have complexity weaved into it because each of these factors is just too big & overwhelming for an investor. The fact that this investment will have an outsized impact – positive or negative – on overall financial wellbeing of the investor, makes this decision that much harder to take.

A house property could be for self-use or be an investment for capital gains &/or rental income. Either way, one ought to take a holistic view of financial as well as non-financial factors, while choosing between the two options because given the sheer scale of this decision, there may be no turning back.

Non-Financial Considerations

Long-Term Commitment – House Property is an emotional need for many & buying it satisfies a heart-felt life goal. Buying a house property is akin to growing roots at one place & is, therefore a long-term commitment. It has to be in sync with one’s vision of career, business, children education & social networking. The emotional connect is integral to ‘buy or rent’ decision, as a big, outsized financial commitment is making an investor choose a physical property over many other possible life experiences. One is effectively weighing loss of freedom (to make many life choices) against the satisfaction of owning one’s home. This decision is very personal for every investor & could be beyond financial considerations.

Stability & FreedomOwning a place provides stability to how life is lived & is free of whims & fancies of landlord. Rent agreements are often drawn in favor of landlord for limited duration & are often not easily enforceable. So, long-term planning with regard to living at one place of choice, cannot be done with too much certainty. Market forces in real estate segment may lead to disruptions on account of fluctuations in rent &/or availability of alternate accommodation in case one is forced to forego rented property. Renting a property could come with restrictions, such as freedom to come & go as one please, food & making alterations to property to suit one’s aesthetics.

Financial Considerations

Financial Stability House Property is a big-ticket item & should be considered for purchase only if finances are found capable of bearing any stress caused by such a commitment. Debt financing over long duration brings to fore importance of the fact that earnings do not get disrupted in extended future & there is sufficient flexibility in the expense budget to endure interest rate hike.

A thumb rule suggests EMI (of all long-term debts) under 30% of post-tax income, is at most sustainable debt to carry. With higher dependency on future income comes the loss of freedom to contemplate any change in regard to ongoing service/business.

Running the formula for Affordability & Prudence The choice between buying & renting involves comparing value of money saved by not purchasing & invested elsewhere with value of property, if purchased.

Buy side of the equation calculates the amount of loan that can be taken or maximum loan that can be raised. The balance has to be paid upfront in the form of down payment. The terms of home loan such as interest rate (flexible or fixed) & the duration are key inputs to arriving at EMI (Equated Monthly Instalment) payable monthly.

  • Cash Outflow = Down Payment + EMIs paid over the entire loan duration + Annual Maintenance Charges (increasing over time) + Property Tax (during the entire loan period).
  • Value of Buy Option = Total Cost of Property (including Taxes) + Growth in Property Prices (assumed over loan repayment period) + Tax Benefit (of buying House Property over loan repayment period)

Rent side of the equation calculates total rent payable over the entire period of corresponding home loan duration, after taking into account likely increase in rental cost over such period. Money not paid out when choosing rent over buy option reduced by Security Deposit paid to landlord, is assumed to be invested over the entire duration.

  • Cash Flow Savings = Cash Outflow in case of ‘Buy’ option (with periodical increase) – Cash Outflow in ‘Rent’ option (including Security Deposit)
  • Value of Rent Option = Market Value of Savings (investment compounding at assumed returns) + Tax Benefit (of renting for salaried persons)

Important Caveats

Benefit of Renting over Buying = Value of Rent Option – Value of Buy Option

Assumptions as to returns, property appreciation, rent increase, maintenance etc. have a huge role to play in this calculation & need to be conservatively made. Be aware of your biases while making such assumptions.

“Price to Rent” ratio compares the total cost of buying (finances, taxes, tax breaks, insurance, commission etc.) to renting costs, thereby estimating the point at which costs of ownership outstrip the costs of ownership.

House Property as an investment

If house property is bought as an investment, comparison is done between

  • post-tax return on alternate investment &
  • post-tax rental yield plus increase in value of property.

If decision regarding sale of a property is to be made then rental yield should be calculated as post-tax rent on current market value & not on original purchase price. Anchoring bias i.e., latching onto original purchase price as reference & not taking effect of inflation & taxation are important factors that can distort the judgement.   

Relation with Risk

Investment Risk is the chance that outcome of an investment is different from what was expected from it. Risk-Return relationship is one of the fundamental laws of finance. There is a positive correlation between the ‘amount of risk’ & the ‘potential for return’. Risk does not always translate into profit, the connection between the two is just that of a higher probability. A higher risk investment has higher potential for positive (profit) as well as negative return (loss).

  • In the short run – Risk is in volatility of price of underlying asset i.e., how much it can rise or fall, given a period of time.
  • In the long run – Risk resides more in loss of purchasing power of money than in volatility of price of asset.

Relating to Risk

Risk is a fact of life for investors. It cannot be avoided but one need not blindly submit to it, either. An investment that has the chance of a higher return is likely to have higher risk but high risk by itself does not mean higher returns. The risk-return tradeoff does not completely apply to an investment portfolio because investor’s behavioral impulses vis-a-vis risk continue to evolve with time. It is for this reason that temperament is considered so crucial to successful investing.

Risk Taking Behavior is determined by

  • Motivation behind investment decision – ‘not losing money’ / ‘making money’
  • Emotional State – fear / greed
  • State of MarketBear market increases risk aversion / Bull markets increases risk taking.
  • Personal Finances Improved finances & Wealth effect increases risk taking.  

The kind of relationship an investor has with risk is largely determined by his/her decision-making biases & psychological weaknesses. Data based or factual assessment of risk is often overshadowed by traits such as

  • Overconfidence that one knows more than the market,
  • Confirmation bias that only looks at supporting data but ignores analysis that goes against investment hypothesis,
  • Loss aversion that takes on long term risk of poor returns while trying to avoid short term risk of volatility,
  • Regret of having missed opportunities could drive investor to take on more than desirable risk.

Recognition of one’s relation with risk could help set guardrails for risk mitigation.

Portfolio Risk

Portfolio risk is a chance that the combination of assets held by you, fail to meet financial objectives. Each investment within a portfolio carries its own risk – but holding a combination of investments that do not depend on the same circumstances to return a profit – reduces risk to achieving the financial objective. Risks only get minimized & are not eliminated entirely. Risk could present itself in various ways.

Mother of all Risks – There is not enough money to fund the overarching financial objective of retirement or that post-retirement there is no money left.

Risk of Asset Mix – The return produced by combination of assets in a portfolio may be so volatile that investor shifts to an ultra-conservative portfolio at an inopportune time or that volatility causes value of the asset-mix to go sharply into negative zone just when investor is close to needing the money, with little time left to possibly recover the losses.

Inflation Risk Asset mix heavily skewed towards debt runs the risk of declining purchasing power over long term.

Cause Concentration Risk – Outcomes responding to the same cause, have same risk even if investment is held over different asset classes. For example, (a) lower rated debt & equity react in same way to health of economy (slower GDP leads to losses in both – even if to different degree), (b) employment in Information Technology (IT) startup & IT dominated equity investment (happenings in IT sector would lead to same outcome).

Portfolio Concentration Risk – Investment in too few stocks (even if high quality) or in few industries (even if number of stocks is large) makes outcome too much exposed to single factor. Cyclical factors or technological shifts could expose portfolio to drastic volatility.

Behavior Risk – Investor is the biggest risk to his / her own portfolio because falling prey to emotions of fear & greed, investment biases & investment indiscipline seriously undermines the outcomes. Chasing ‘returns’ in greed & seeking ‘safety’ in fear, has the same impact on an investment portfolio.

Portfolio Positioning

An investor seeks the most acceptable trade-off between risk & reward, while investing in a collection of assets with different weights and that is done in context of one’s

  • Risk Capacity – Ability to take risks. Financial goals & time horizon for each of them, helps draw parameters for risk capacity.
  • Risk Tolerance – Ability to withstand those fluctuations (variability of returns) without having to change the plans. It is the ‘anxiety-adrenaline’ framework of an investor, beyond which an investor is prone to making ill-advised moves.
  • Risk Appetite Willingness to take risk. Not a measure of how much risk we can take. It is an appreciation of how much risk to take i.e., Risk Appetite = Risk Awareness.

What to do in case of Mismatch between Risk Capacity & Risk Tolerance?

High Risk Capacity – but – Below Average Risk Tolerance – Employing hybrid mutual funds as core holdings &/or holding equity-based portfolio with diversified set of more conservative securities can tamp down volatility without entirely sacrificing the upside potential of equity.

High Risk Capacity – but – Low Risk Tolerance – Employing value-oriented & Equity-Savings mutual fund portfolios that primarily seek to protect the downside.

Low Risk Capacity – but – High Risk Tolerance – Bucket Strategy that segments the portfolio by time horizon, would earmark short-term debt for short to medium term goals & allow an investor to safely invest in more volatile assets. 

Risk Averse investors – Practice good portfolio hygiene by focusing on quality of the portfolio composition. Also, employ disciplined rebalancing to remain confident about the portfolio positioning vis-à-vis the time horizon.