Wealth Creation of Equity MFs

Superior returns of ‘equity’ & compounding of such superior return, is key to wealth creation. To tap into asymmetric upside of equity investment, one has to successfully overcome the challenges of stock selection (i.e., fundamentals, valuation, pricing & risk assessment) and timing of transactions (purchase & sale). It requires a certain operational & knowledge bandwidth, to achieve even a modicum of success. That retail investors have not been too successful, is borne by historical data that points to a wide gap between market returns & what investors have in fact achieved. The biggest challenge for investors is that it’s not easy to mitigate risk.

Mutual fund investment presents a much better alternate to direct participation by investors, because of its structure, regulatory overview, professional management & better resources at its disposal. It also affords operational flexibility & tax efficiency, that translates into a better risk-adjusted return.

The disclaimer that Mutual Fund investments are subject to market risks & past performance of the mutual funds is not necessarily indicative of future performance of the schemes, should not be taken lightly. Stock markets are in a state of constant evolution, wherein financial intelligence, capital, randomness & luck play their part in equal measure. The investor has to make sure that investments remain aligned to the risk profile, planned asset allocation & financial objectives.

Following is the list of 10 Mutual Fund – Diversified Equity Schemes (Growth Option), that have created most amount of wealth – over last 25 years. The following list is not a recommendation to invest. It just reflects the possibility & the capacity for superior wealth creation. It points to a need for reflection whether the equivalent results have been achieved by you or if you are just starting out, to make best use of the time ahead for you.

It is important to note the impact of ‘Survivor Bias’ when returns of popular benchmark indices such as S&P BSE Sensex & Nifty 50 are referred to. Sensex was launched on 01st January 1986 with back dated data from base of 100 as on 01st April 1979. Similarly Nifty 50 was launched in 1995 with back dated values from 1990. The back-dated Sensex till 1986 has generated a fabulous CAGR of 28.71%. Sequencing of returns i.e., high returns in initial period significantly improves index return since inception, despite lower return post 1986.

Scheme Selection should be in context of investors’ personal finance & all the ‘musts’ of prudent investing.

  • Wealth Creation needs both time & returns.
  • Longer time & Superior returns create the perfect magic.
  • Mutual Funds in India have been able to achieve even better outcomes than benchmark indices, since the times it has been in operation.

The caveat is that the scheme would have remained invested over the entire period – in all seasons of economic performance & stock market volatility.

Wealth Creation of Equity Investment
Investment of Rs. 1 lakh in S&P BSE Sensex – on Reference Date
Current Value of Rs. 1 Lakh Investment – as on 04th July 2022
IndexReferenceDatePeriod (Years)CAGR % since inceptionValue as on 04/07/2022 (Rs.)
S&P BSE SensexBase @ 10001/04/197943.2915.615,32,34,770
S&P BSE SensexLaunch @ 549.4301/01/198636.5313.3496,89,091
S&P BSE SensexEarliest MF @ 3292.8501/12/199328.6110.2216,16,678

Wealth Creation by Diversified Equity MF schemes over last 25 Years
 
Asset Management by 10 Mutual Fund Houses
 
Rs. 1 Lakh Investment on 05th July 1997
Sno.SchemeScheme LaunchCAGR %
(over 25 Years)
Market Value
on 04th July 2022
(Rs.)
1HDFC Taxsaver FundMar-9623.842,09,66,386
2Nippon India Growth FundOct-9522.171,49,31,875
3Franklin India Pima FundDec-9321.251,23,60,718
4Aditya Birla SL Tax Relief 96Mar-9621.011,17,63,364
5Tata India Tax Savings FundMar-9618.9776,90,181
6DSP Flexi Cap FundApr-9717.9261,61,504
7Nippon India Vision FundOct-9517.6257,81,352
8ICICI Prudential Multicap Oct-9417.0150,76,618
9Sundaram Tax Savings FundMar-9616.3944,45,204
10Canara Robeco Equity Tax Saver Mar-9315.3135,21,067
Nifty 50 Index – as on 04th July 2022 – 16,214.70 
Nifty 50 Index – 25 years ago at 1216.10Jul-9710.81%13,00,313
Nifty 50 Index – since Inception (Base of 1000)Nov-9510.91%15,83,535

‘Buy & Hold’ – Ifs & Buts

‘Buy & Hold’ is a passive investment strategy in which an investment is held for a long term, regardless of fluctuations in the market. As owner of businesses, investor creates wealth through compounding of superior returns, without getting distracted by volatility of stock markets.

‘Timing the Market’ is tactical asset allocation strategy in which equity is sold when market valuation is considered expensive (or has lost momentum) & re-invested into when valuations become cheaper (or has gained momentum).

The case for ‘Buy & Hold’ Strategy is made out on the basis that stock market is directionally upward biased, on account of its link to corporate profits. Economic growth & efficiency of businesses finds reflection in rising profits & stock markets are thus structurally primed to move to newer heights. Any negative volatility along the way, is sure to be overcome by positive volatility that follows. Random Walk Theory states that past movement or trend of a stock price / market cannot be used to predict its future movement.

‘Buy & Hold’ strategy discounts any benefit of timing the market (avoid the downturn & reinvest in the upcycle), as it is impossible to outperform market without assuming additional risks. It is important that investors not fall prey to overconfidence bias that prompts them to overestimate their ability to forecast the trends of stock market & therefore time the market. The strategy holds that it is not possible to consistently add value to portfolio returns by doing so.

Uncertainty, possibility of unknown risks & luck plays an important role in progress chart of every investment. This presents many technical & behavioral challenges to successful timing of the market. Staying invested is no different although it poses a different set of technical & behavioral problems. ‘Buy & Hold’ investor keeps investing through bearish phase, waiting for a big year with bumper returns. Is this not timing by indirect means? Basing the investment strategy on the assumption that market has to go up, is not without inherent dangers.

Historical data of stock markets is put forth to support the efficacy of this strategy by showing that markets have generated strong compounded returns despite regular bouts of negative volatility. Also, that bull markets are characterized by many intermittent falls & bear markets too witness strong upward movements within the downturn. The opposing short-term counter moves & pervasive uncertainty of the market, could be a trigger for an investor to stay out of the market & thus make him lose more waiting for the correction than what he would otherwise lose by the correction itself. ‘Buy & Hold’ strategy absorbs the pain of downward correction while capturing the complete gain of secular economic growth. 

No doubt Nifty 50 index has moved from 1000 in November 1995 to 17583 as on 24th Sep 2021 @ CAGR of 11.46%, (excluding dividend).

It is also true that

  • Nifty 50 Index gave NIL returns between financial year end of 1995 & 2003 – 8 years. Is this short term, medium term or long term?!? It is important not to shift expectations with different sets of data.
  • 10-year SIP in Nifty 50 index (incl dividends) as on 23 March 2020 (Nifty 50 @ 7610) produced XIRR of 1.69%.
  • 14-year SIP in Nifty 50 index (incl dividends) as on 23rd March 2020 produced XIRR of 3.76%.
  • Dow Jones Industrial Average reached 919 in May of 1968, & by August of 1982, had fallen to a level of 777, for a loss of 15% in 14 years. The real value of the Dow drops to 274 if we consider purchasing power of Dollar (35 cents to a dollar in 1968), then stock portfolio is down by a staggering 70%. 

Secular bear markets are entirely real, they are the reality of history. It is the idea of a bear market being a brief & reliable buying opportunity that is myth, over the long term & needs to be reassessed.

‘Buy & Hold’ strategy places a huge premium on the magic of compounding to eventually compensate the negative returns of bear phase. One needs to appreciate the limitations of compounding & risk that come with blindly believing that it works in all situations. An investor cannot afford to ignore ‘Sequence of Return’ risk in his financial planning. This risk comes from the order in which investment returns occur. The return – at the beginning of the period of investment &/or at times when large investment is put to work – carries more weight in the overall results. Same set of return percentages over an investment period but in different sequence, could produce very different outcomes. This is where the luck comes to play such a vital role in the investment process.

Warren Buffett is held out as a poster boy of ‘Buy & Hold’ strategy since he advocates holding onto good companies for eternity. Success of Berkshire Hathaway in compounding gains over so many decades, is held out as conclusive evidence of efficacy of this strategy. It needs to be remembered that his wealth size, knowledge & managerial bandwidth, stable behavioral impulses and participation in best period of American economic growth & political dominance (luck!?!) have played an important role & his success cannot be attributed to the strategy alone.

Buy & Hold’ is not an all-weather solution that it is made out to be but rather a strategy that should be used in certain circumstances & with certain caveats. Justifying a strategy of buying & holding in all market conditions, on basis of performance of indices that are actively managed, is quite an irony. The implication of this strategy that prices do not matter & investment can be held under all conditions, is a flawed investment philosophy. If the risk of buying & holding securities is not commensurate with the reward, under conditions that are mathematically assessed (& without benefit of hindsight), then it cannot be the case that higher returns be pursued with complete disregard for risk management.

Expense side of the Equation

Financial intelligence is key to successful management of finances. Widespread financial stress among the household points to a huge disconnect between the demands of prudent financial behavior & what the vast majority actually does. The stress mostly stems from low levels of financial reserves. Saving is the difference between the earning & expense. While the earning aspect is rightfully the focus of much attention, spending aspect does not get as much mind space. It is treated as a downstream effect of earning the income & is largely ignored as far its impact on wealth creation goes.

The obvious benefits to spending less are saving money for investment, paying down debt & freeing up room for really important stuff. To fix the approach to spending & take accountability of financial decisions, one has to know the nature of the expense to find its solution.

Expenses could be of any of the following nature –

  • Fixed – Standard expenses that happen every month at a certain date – EMIs, electricity, memberships, subscriptions, internet
  • Recurring – Day to day expenses – groceries, petrol
  • Non-Recurring – Annual or few times a year – clothes, shoes, social events
  • Unpredictable – House repair & maintenance, car breakdown, medical emergency

Spending Mindset

The key to making progress towards financial freedom is a mindset that frees oneself from shackles of circumstances & takes control of life & money. Unless, lifestyle is aligned with the objective of financial freedom, any effort on managing the expenses will amount to little. There is a sliding scale to attacking expenses & it all boils down to the mindset, with which one approaches one’s spending.

Frugality is at the severest end of expense scale & is the lifestyle option where in lowest cost & zero waste solutions are targeted each & every time. The sharp focus is on price & utility, instead of quality or brand value. Hunt is always on for the best deal, buying in sale, using coupons, free use options etc. It is a serious attempt to stretch the rupee as far it goes by upcycling current possessions & finding ways to improve available stuff. It is the only viable option available for those with limited potential for income increases &/or for those in debt trap. Savings however little, can be invested into assets that generate income, thereby loosening the stranglehold of poor cash flow. With strict control on expense & increasing income, opportunities open up.

Minimalism is the more evolved lifestyle mindset, income side permitting of course. The philosophy of minimalism is to liberate oneself from the clutter of unnecessary belongings. Such lifestyle is wanting to live with less, buy only what is needed & keep only things of value. It strives to limit oneself to things & experiences that truly matter & define you as a person.

Financial minimalism works towards freedom to enjoy life, overcome stress of constant consumerism & financial freedom. It is best achieved by tracking your expenses & segregating them into ‘wants’ & ‘needs’. Half the battle is won if one is able to identify the spending which only gives momentary pleasure & does not contribute to personal growth. The ‘Pareto Principle’ (the 80/20 rule) applies to everyday life as well i.e., often 20% of our possessions are used 80% of the time & therein lies potential for eliminating the long tail of expenses that create clutter & stress. Such an approach leads to more intentional buying that gives better value over time but may not necessarily be the cheapest option.

Keeping-Up is much of the middle-class experience. Just as income begins to flow into enough-but-not-too-much region, that expectations of society & peers begin to guide lifestyle choices. Comparing oneself to others at same or level above, is a human frailty that is omnipresent & leads to financial decisions that are psychologically & financially self-defeating. Life happens day by day & one needs to be conscious enough & disciplined enough not to be dragged into living a life that you are expected to live as against life that you want to live, in order to be happy. The financial cost is paid in form of being in debt, always playing catch-up, accumulating things that are not used or just being in stress of living somebody else’s vision.

Profligate lifestyle is the other extreme of frugality, in which all things are defined on materialistic scale. The latest, the largest, the best, the flashiest or just the costliest, is where spending is directed. Such lifestyle is more often than not facilitated at the start by availability of too much income or wealth but no wealth is large enough to forever sustain a profligate lifestyle. History is a witness to many examples of kings & rich celebrities falling into financial distress, as well as those who have lost everything in an attempt to be seen in a select circle. Profligate spending is antithesis of wealth creation. 

Lifeblood of Financial Freedom

Financial Freedom is possible for anybody who has moved beyond the subsistence income level. The formula is simple but needs lifetime commitment to it. Management of expenses is fundamental to building the corpus & sustaining it for an undefined period. It is a key hurdle to cross. The journey towards financial freedom is going to be short lived if we continue to pursue fulfilment in material possessions. The pleasure of the new dissipates very quickly & the dissatisfaction of not having something else returns. No amount of spending can cure discontent of that the chase for better lifestyle is trying to find. The lifeblood of financial freedom is to be content, find value in life experiences & being satisfied with current situation.

Leverage your Income

Leverage is a term used to describe action of a ‘lever’ i.e., moving object much heavier than the available force. It is used to describe something that magnifies the advantages so that work gets done with much less effort – conversely, same effort produces more output. It is the strategic effort to remove the bottlenecks in the path of a person’s financial progress. Such expansion of resources vastly improves productivity & produces a downstream effect of accelerating income. Leverage is the reason behind stupendous success of some 20, 30-year-olds, which is otherwise not achieved over lifetime of work by others. Financial success is more a matter of working smarter & not harder.

Time is a finite resource – limited working hours each day of the limited working life. Expanding this resource by leveraging the time of others & getting more work done is the surest way of turbo charging the income growth. It will be a huge compromise if income is left to its natural linear growth by remaining within the confines of one’s own time. Primary purpose of leveraging time of others is to increase productive segment of each working day – hours spent on doing the kind of work that makes a difference, creates value. This intent is significant because such productive time is just 10% of the day, rest is just routine (even if, essential) work.

Finding more hours for high value-added work automatically leads to better productivity & higher income. It is possible to remove oneself from the nitty gritty of business by mapping repetitive tasks into standard procedures, to be automatically followed by employees. A manual of best practices saves time of both management & the workers. Benchmarked against one’s skill set & time-value, activities that are less valuable should be delegated to employees to free oneself for more important work. Such leveraging of time not only increases overall capacity for work that increases top line income, but also improves profit margins through more value-added work.

If machine labor is able to replace human labor, the results are cheaper, faster & less error prone. Leveraging efficiencies of technology & standardization of processes has the potential to dramatically shorten the lead time to growth of business & income. Growth demands new clients & long-term value proposition from every client. Technology driven & customer centric solutions can deliver steady flow of prospects via automated marketing & lead generation system, convert such prospects into business & collect payments, while delivering value & accountability better than fully trained staff.  Primary examples are fintech, banking & brokerage companies that have tapped the un-serviced markets in fraction of the time, the old school businesses take.

A framework that facilitates – new client acquisition at low marginal cost, provides instant feedback from prospects, delivers value added communication to clients & builds brand loyalty – pretty much, does away with all limitations to growth.   Fast communication network & social media innovations give access to an audience many times more than what was previously possible. As one moves beyond the limitations of physical presence for growth, the potential for income improves dramatically. Success of communication & marketing leverage in scaling up revenues in a compressed time span, is the reason celebrities, entertainers & social media influencers get paid so much more than those who deliver more critical / superior services (such as teachers, police, doctors etc.).

Good advice, expert knowledge & deep experience are invaluable, for the reason that these are always difficult to access. A strategic alliance with right people helps you do more, do it faster, with greater upside & reduced risk. A network of relationships is an eco-system wherein receiver gains immensely (contacts, referrals, strategies, knowledge, support etc.) & there is no cost to giver. This exchange of value without any quid-pro-quo, is premised on sharing the individual strengths & would, of course take long time to build. Leveraging such relationships can significantly compress the learning curve, reduce risks & compound gains through better decision making.    

  • Knowledge is the source of innovation.
  • Innovation is the source of competitive advantage.
  • Competitive advantage is the source of profits.

Capacity to learn & time needed to learn, are key constraints to maximizing the knowledge resource. This limitation can, however be overcome by hiring experts & making their knowledge available to the whole organization by documenting the knowledge & incorporating it into systems & processes of business. Better still, one can become an expert & leverage the knowledge for higher income.  

Financial Leverage is best understood, widely deployed but is also the riskiest. It is using money of others to overcome limitation of own capital. Debt financing, mortgages in real estate, margin money in stock market operations etc. are examples of filling the capital shortfall. Such leverage has a cost attached to it, in form of interest to be paid on outstanding loan. Risk profile of financial leverage is dependent on the purpose for which outsider capital is used. If it leads to an asset, the value creation of which is much more than interest cost, then it is a wealth creation agent. In other cases, it burdens the finances & can have a very debilitating effect on business.  

Retirement Finances – Before & After

Financial planning for retirement is a look into an uncertainly long future & is doomed to fail if it is not aligned with the vision for post-retired life, retirement age & the health status of retiree. The key to a secure retirement is in accumulation of a retirement corpus large enough to support the visional lifestyle, even as earned income has ceased.

Using MS Excel to manage Retirement Finances

Financial Projections have to be based on certain assumptions – some guesstimated, others unknowable & thus should be dynamically monitored. MS Excel works well for recording, calculating, tracking & revising the data.  

Essential inputs required to plan the retirement finances

Life Expectancy – It is the age of the person, who is expected to survive other members planned for. The plan should be for the person & life partner. Children are expected to plan for themselves, after they become capable & should be included only in exceptional circumstances.

Time Span of Plan = Number of years for member expected to live longest less Age of person making the plan

Retirement Age – Retirement Age may be mandated by terms of employment & would be the age till when earned income is expected to come. If it is not, then assume a realistic number, given the type of work one is doing. Also, factor in technological changes, health & effects of ageing, that might force such retirement decision on a person.  Just because one wishes to work for forever, does not mean that is going to happen. A long-term trend is that of declining work life.

Round off your age to the next digit as at the start of financial year. Age reference allows for better planning over various milestones in the life cycle, besides reinforcing the desirability of sticking to the plan. Rip Van Winkle isn’t be the last one who woke up late. Most people just do that & miss out on major opportunities in life.

Desired Annual Retirement IncomeWhen earned income stops coming in, then accumulated savings get dipped into to maintain the desired lifestyle. The vision for retired life & where it is going to be lived, determine the kind of expenses needed to be made.

Inflation during the time between planning stage & actual expenses, reduces the purchasing power of currency & larger funds are required to compensate for this loss of purchasing power. So, expenses budgeted as per present scenario, need to factor in compounding effect of inflation over the entire time span of plan. Till the retirement, inflation cuts into the capacity to save & after retirement, would affect sustainability of withdrawals (& income tax incidence, in case required income breaches minimum tax-free limit).

Future Value of Budgeted Expenses >>> =FV(rate, npr, pmt, [pv], [type])

Where,

rate = annual inflation rate (%),

npr = total number of periods,

pmt = budgeted annual expenses (or previous period’s expense),

[pv] = (exceptional) constant expenses during certain years,

[type] = 1, if expenses are in beginning of period or 0, if at end of period

Contribution to Corpus – Retirement Corpus is built on the bedrock of investment of savings & returns earned on such investment. The plan should assume ‘Savings Rate’ i.e., savings as percentage of pre-tax income, planned to be invested (not in rupee terms). That would progressively increase investment amount & put a check on disproportionate increase in expense with increase in income.

Return on investmentAsset allocation largely determines the returns expected from investment portfolio. Weighted average return of all asset classes could be taken as assumed return. Such assumption should be conservative & based on long term trends. Risk tolerance is key to deciding the asset allocation before retirement & becomes even more important in post-retirement scenario. A change in asset allocation with passage of time, would change the return assumption.

The degree of risk assumed in accumulation as well as distribution stage, has a great impact on the type of retirement one gets to enjoy. Avoiding volatility risk by placing too much reliance on debt segment, leads to declining purchasing power with time. At the other end of spectrum is taking too much risk to improve returns & shore up the retirement corpus such as short-term trading, speculation, penny stocks & unregulated products. It could prove highly damaging to retirement plans if it leads to capital losses & there isn’t enough time left to recover from the setback.

Income Tax Impact Marginal Rate of income tax should be assumed, where applicable. Marginal Rate is income tax paid after claiming exemptions & deductions, as percentage of gross income. Tax rules as on date should be assumed to continue. Any change be incorporated as & when notified by the government. Income Tax impact is significant before as well as retirement & should not be ignored.  

Lump Sum Payments It could include real estate & vehicle purchase, as well as sequence of return risk loss.

Post-Retirement Income / ReceiptsIt could include annuities, pension, business income, freelancing income, royalties etc.

Legacy Legacy desired to be left for the dear & near one should be assumed. This balance amount would remain after all those for whom the retirement plan was made, have passed away.

Excel Calculations

Column AColumn BColumn CColumn
D
Column
E
Column
F
Column GColumn HColumn IColumn JColumn KColumn L
Financial YearAge (years)Corpus (Opening Balance) (in Rs.)Contribution (in Rs.)Investment Return (in Rs.)Post Retirement (Income /Receipt) (in Rs.)Expense Need (adj. inflation & tax) (in Rs.)Expense Need (pre-tax & post-inflation) (in Rs.)Corpus (Year End Balance) (in Rs.)Corpus Gap (in Rs.)Required increase in Savings Rate (%)Required reduction in Expenses Rate (%)
            
            

Column A – Financial Year – a row for every year till the last year of expected life of surviving member.

Column B – Age First row has age rounded off to next digit. Number of rows will equal life expectancy of plan.

Column C – Corpus Opening Balance (in rupees) – First row is current market value of total financial assets. Each succeeding row has corpus amount at the end of previous year.

Column D – Contribution (in rupees) – Each row has savings for that year (savings rate as % of pre-tax income till retirement)

Column E – Investment Return (in rupees) – Return for each row is as per formula >>> Column C*Investment Return%

Column F – Post-Retirement Income/Receipt (in rupees) – Post-Retirement income is deducted from Expenses Need (before tax) for the year & if any balance remains then it is included in the row for such year.

Column G – Expenses Need (Inflation & Tax adjusted) (in rupees) – Till retirement earned income takes care of expenses, so nil amount in each row till retirement. Starting from row of first retirement year >>> FV of budgeted expenses for first year of retirement as per compounded inflation rate & each subsequent row is calculated by formula >>> Previous Year*(100+Inflation Rate). Include any lump sum payment in the row for that year.

Column H – Expenses Need (Pre-Tax & Inflation adjusted) (in rupees) – It starts from row of first retirement year >>> Column G of first year of retirement*[Marginal Income Tax Rate/(100-Marginal Income Tax Rate)*100] & each subsequent row with same formula.

Column I – Corpus Year End Balance (in rupees) >>> Column C+D+E+F-H  

Column J – Corpus Gap (in rupees) >>> Sum of all rows with negative balance in Column I & Legacy (in rupees)

Column K – Savings Rate Increase (%) Required – Present Value of each row in Column J >>> =PV(rate,nper,pmt,[fv],[type])   

Column L – Expense Rate Decrease (%) Required – To the extent Savings rate % not possible, Present Value of balance amount to be reduced for each row.

Planning the Retirement

Retirement Planning is getting prepared for transition from an active income yielding working life to a phase with partial or no work. It is the strategy to meet financial & non-financial challenges, that would inevitably follow. Getting this process right leads to a life of freedom, fulfilment & financial security but going unprepared into retirement could mean dependence, penny pinching or even poverty.

Plan for retirement is a specifically designed framework for meeting expenses & liabilities of all those dependent on income of retiree – once earned income ceases. Such kind of life time endeavor, needs a holistic approach that is not only true to one’s core values & finances but also cognizant of the limitations of forecasting too long into future.   

Big Picture of Retirement Planning

Retirement Planning is much more than mathematical projections & it is essential to do it right the first time because the stakes could not be any higher. There are no second chances waiting in retirement & mistake(s) could do irretrievable damage. It is important to keep an eye on the big picture of this extremely crucial subset of personal finance. Be financially literate, make this your highest priority, set goals in writing & remain committed to them.

Underlying Assumptions hold the key

A plan of such long-term future has to necessarily factor in many variables, some of which are guesstimated, while others are simply unknowable. Retirement plan & its’ mathematical calculations are only as accurate as the underlying assumptions, on which these are based. The essential inputs required to plan are –

  • Retirement Age,
  • Life Expectancy,
  • Savings Rate,
  • Inflation,
  • Return on Investment – before & after retirement,
  • Savings Withdrawal Rate
  • Health Insurance Needs

With so many moving pieces, this jigsaw puzzle will not have easy answers. The plan, if it has to any chance of success, has to be true to planner’s core values & assumptions should reflect these values.

Savings Rate

It is never about the amount one saves but always about savings as percentage of post-tax income. This perspective immediately takes victimhood, low income or any such excuse out of the equation & does not give even a toe-hold to procrastination. The rationale is that income should support the lifestyle & savings should be treated as payment to your future-self. What is left after savings is only to be expended.

Saving is not an option, lifestyle is. Income & expense are two variables of this conundrum. If income is found insufficient to meet expected lifestyle standards, then solution lies in increasing income through harder work & leveraging of – knowledge, time, technology, communication, marketing, network & (risky option) finance. On the other hand, expenses should be viewed from prism of need vs. want &, if need be, reduced through minimalistic lifestyle.

Savings should accumulate to a corpus sufficient to sustain lifestyle over retired-life span, which could be as long as the working life. High savings rate & minimalism are key to early retirement, if that is the ambition.

Golden rules of Investment

Nothing damages retirement vision as financially illiterate investments. Most retirees have a long investment horizon – 30 to 35 years of working life & as much after. Viewed from a five to six-decade perspective, time tested golden rules of investment are key to successful retirement phase. Consequence of financial apathy is more mistakes, greater losses, reduced investment return & less wealth.

  • Financial Education shortens the learning curve of wealth creation
  • Asset Allocation overwhelmingly affects investment outcome
  • Investing for inflation adjusted return – with positive payoff expectancy
  • Risk Management prevents life altering loss – in particular, ***’Sequence of Return’ risk
  • Goal Based Approach prioritizes life goals over return & volatility
  • Investment Plan detailing investment selection process, valuation & expected return

***‘Sequence of Return’ risk could have an outsized impact just before retirement when retirement corpus is at its peak & post-retirement, when withdrawals are planned based on return assumption. This risk needs to be mitigated by building income ladder, progressively reducing volatility, flexible management of expenses & maintaining cash reserves for short term needs.

Concept of Compounding

Compounding is the process of generating income on asset’s reinvested earnings. With every passing year, the size of ‘return on accumulated returns’ increases at geometrical rate & not average rate. Influence of compounding increases with time. When the retirement plan duration is short, the compounded effect of return & inflation is not much. Compounding gets to play a role in retirement plan, only if reasonably long period is allowed for it. 

Retiring Early Compounding effect neither increases savings rate required to replace income need nor reduces purchasing power via inflation effect on expenses, if time left to retire is 10 years or less. Higher savings rate overrides any compounding concern. The necessary conditions are that one has to be satisfied with present living standards, save 70% of income & have 3% withdrawal rate.

Compounding of Returns in Normal Retirement – Procrastination is said to be wealth suicide in instalments precisely for the reason that it reduces time for positive impact of compounding to present itself in all its’ glory. Every bit of delay in starting the savings for accumulation of retirement corpus, costs dearly. A thumb rule suggests that delay in savings for retirement by 6 years would double the required savings rate.

‘Rule of 69’ computes the number of years it will take to double the money, given the compounded annual rate of return (T = [(69 / R) + 0.35]. Giving more years to investment creates twin advantage of superior retirement corpus & smaller savings rate requirement. Thus, perfect recipe for successful retirement is a combination of improved return on investment & starting the savings programme early in one’s career.

Compounding of Inflation in Normal Retirement – Inflation reduces the purchasing power of wealth & compounding effect accelerates the process over time. ‘Rule of 70’ can calculates years in which future purchasing power reduces to half (70/Inflation = n).  That translates into higher need for funds to sustain the desired lifestyle & unless one has saved enough, choice is between downgrading lifestyle or running out of funds in your lifetime.

The greatest threat to retirement investors is the wealth-destroying triple combination of Monetary Inflation (due to increased money supply), Asset Deflation (reduction in value of asset), & Inflation Taxes (tax on inflation component of capital gains). Inflation is particularly tricky to factor in retirement plan as rate of inflation is different for different segments of population & post-retirement period is very uncertain. 

Preparing for Retirement

An ideal retirement is in accomplishment of life goals & fulfilment of all the dreams that one had held on to, till this moment of transition. The golden age should not see any remnant of regret from losing out on active value creation, status or earned income. It ought to be fuelled by passion, creativity & everything that gives a sense of purpose.

Vision of Retired Life

One can, either go through life oblivious of what truly drives your happiness or have a vision of kind of life that is truly worth living. Indecision lets circumstances decide for you but dreams & goals guide you to the path of your own choosing. So, setting goals for retirement is an absolutely essential first step towards retirement.  

Dreaming up vision of a perfect retirement, translating into a satisfied life, may feel as daunting as the times when choices of career & marriage had to be made. Give a thought to all the passions, experiences, learnings & activities that had to be deferred, so that your working life could prosper. Whatever one’s plan for perfect future be, it has to be in consonance with life partner, because it is better to be on same page before any financial or emotional commitment takes place. It is important to realize that retirement cannot just be a winding down phase.   

A vision for a special retired life not only motivates you for limitless possibilities ahead, it also sets out markers for when to retire & ‘cost of retirement’. Serious financial planning can begin only when the contours of desirable retirement are in place.

Where to retire

Localizing the post-retirement life is a sub-part of vision for retired life but could also be linked up with finances of retirement. This decision impacts the cost of retirement or could be impacted by the limitations of resources available to fund the retirement. Vision for certain environment, infrastructure or status could drive the choice, say for example a beach house, glamorous part of city, access to health facilities, employment or social life etc. The choice, though has to either meet the affordability criteria or drive the affordability agenda. One could choose to move to a lower cost area if it helps ease up pressure on finances or make certain experiences possible.

Retirement Date

Date for transition to retirement (or a partial one) may have been decided very much the moment one joined the employment (government job) or it could be of one’s own choosing (private sector or own business). This date provides some exactitude to the retirement plan by defining the period left for earned income, its’ downstream effect on savings, investment & retirement corpus as well as the post-retirement period that can be financed with less or no earned income. One may have to postpone retirement, if it is felt that finances fall short of demands of retirement.

Retirement Corpus – Affordability Scenario

Subject to the vision of retirement & time left to retire, the preparation now is at the affordability doorstep. This puzzle of ‘fulfilling & financially secure retirement’ is a complex one, given that an uncertainly long future is being forecasted, based on unknowable assumptions. As consequences of a miscalculation can be quite serious, both optimistic & pessimistic scenarios should be developed, which then can be improved upon as more & more data becomes available.

Projections of an affordable retirement are based on

  • budgeted expenses of the retired life,
  • accumulated pension funds,
  • investments,
  • returns on investments &
  • rate of withdrawals from corpus.

Health Care is the trickiest area of planning because proper insurance eats up a chunk of income but no insurance can create risk for expensive treatment. Future health & associated health care costs (including old age care) are a big unknown. It is better to err on the side of caution as much as finances allow.

The gap between the accumulated corpus & demands of the desired vision, can be bridged by increasing income during retirement &/or reducing budgeted expenses. Income could be bumped up by delayed or partial retirement, disposing of unused valuables & reverse mortgage of house property. Depending on the gap still to be covered, the vision for retirement either be reworked from scratch to realistic levels or be scaled back. ‘Rule of 300’ says that each monthly expense needs assets 300 times its size, to support it. So, a reduction of post-retirement monthly expense by Rs. 1000/- should reduce retirement corpus needs by Rs. 3 lakh. Expenses or luxuries that do not contribute to core, desired life experiences, must be the first ones to be put on chopping block.

Legacy

A life of freedom, fulfilment & financial security is incomplete without attending to all that is integral to business of living & dying. Legacy should be protected by estate planning which includes will, nominations & power of attorney. A master file should be maintained with all necessary documents, properly organized & listed, so that heirs do not have to do your work, the hard way –

  • Financial accounts with account numbers, contact information, addresses, nominations & latest statement of annuities, life insurance, investments, loans, etc.
  • Wills, Powers of Attorney & other Estate Planning documents
  • Identity documents, Marriage certificate etc.
  • Property deeds
  • List of valuables & safe deposit box key with listing of what’s inside the box

With the above groundwork done, you are now set for the mathematics of retirement planning.

Retirement Landscape

Retirement

Retirement is the fact of ceasing to work, due to employment terms, disability or choice. The practice of retiring on reaching a certain age, has been around since the 18th century & started being adopted as a government policy during the late 19th century & the 20th century.

Economic prosperity has allowed more people to move away from manual labour & also live longer & healthier lives. This structural shift has enabled a move away from compulsion of lifelong work & allowed retirement to become a life-cycle choice. Disability could be the exceptional cause that pushes a willing person out of work force.

Retirement could take one of the following forms –

  • Traditional RetirementQuitting work for good in favor of leisure &/or passionate interests on reaching certain age of seniority.
  • Early RetirementTaking a break well before average retirement age, to pursue passions & enhance life experiences.
  • Semi-Retirement Taking leave of working life but using expertise in consultative or entrepreneurial capacity with scaled back engagement & flexible hours.
  • Temporary RetirementOne may feel the need to take a temporary break from work, particularly jobs with long hours, stressful environment & technological redundancy. Retirement could be of uncertain duration with option to going back to work in previous or new area.

Retirement Decision

The decision to retire – type & timing – is driven by following parameters:

  • Well-Being – Life of comfort with a suitable social & entertainment eco-system.
  • Finances – Ability to maintain lifestyle, preserve savings & leave a legacy.
  • Health – Access to quality health services.
  • Employment & Infrastructure – Access to civic amenities & employment hubs.
  • Quality of life – Clean, safe environment in which to live

Ecosystem to Retire Well

A holistic approach is needed to make success of post-retirement life because demands of happiness do not change with this cessation of full-time work.

Psychological Factors – The switch from a fully engaged working life to partial or full retirement has its psychological toll irrespective of the reason behind this transition. Adjusting to retirement is difficult because feelings of boredom, anxiety & restlessness permeate the various stages of retirement, that everyone goes through –

  • Pre-Retirement
  • Retirement
  • Disenchantment
  • Reorientation &
  • Reconciliation & Stability.

Societal & personal expectations present a mental challenge during the tectonic shift that retirement brings about in one’s life.  It is important to prepare for all the major & minor likely changes, so that one is not overwhelmed & can gently ease into this new stage of life. Importance of support group of family & friends, cannot be overemphasized.

Financial Factors – Retirement implies an end to stream of earned income & complete/increased dependence on accumulated savings for living out the post-retirement years. The fundamental problem is that this is akin to forecasting the future & involves putting real numbers to it. There are just too many moving parts to this puzzle. The estimate of corpus that could finance the retired life & savings required over working life to reach such a figure, can only be as good as the assumptions on which it is based.

Projecting long into the future with unknowable assumptions & basing one’s financial future on such conclusions is a risky bet. Life could pan out anywhere between highest estimate (with pessimistic assumptions of high inflation, low investment return, long life expectancy) & low-ball estimate (optimistic assumptions of low inflation, high investment return, early death) of money needed to retire. The process of estimating retirement needs has to be regularly improved, based on what did occur since the last calculation. One can safely conclude that fountainhead for successful retirement is healthy finance.

Journey of ‘Nifty 50’ Index

Nifty 50 Index is composed of 50 of the 1600 companies traded on the NSE. The base date of the index is November 3, 1995 (1st anniversary of the NSE) & the ‘Base Value’ is 1000 with a ‘Base Capital’ of Rs. 2.06 trillion. The level of the Index reflects the total market value of all the stocks in the Index relative to the base period November 3, 1995. The index started trading in April 1996. From 2009, the index was created using the float-adjusted market capitalization-weighted method.

BSE Sensex price was 124.15 as on 3rd April 1979 (by back-calculation). Actual trading began only in 1986.

Nifty 50 Index – Financial Year Milestones

DateNifty 50Yearly Gain %
31/03/1995990.24
29/03/1996985.30-0.50%
31/03/1997968.30-1.73%
31/03/19981116.9015.35%
31/03/19991078.05-3.48%
31/03/20001528.4541.78%
30/03/20011148.20-24.88%
28/03/20021129.55-1.62%
31/03/2003978.20-13.40%
31/03/20041771.9081.14%
31/03/20052035.6514.89%
31/03/20063402.5567.15%
30/03/20073821.5512.31%
31/03/20084734.5023.89%
31/03/20093020.95-36.19%
31/03/20105249.1073.76%
31/03/20115833.7511.14%
30/03/20125295.55-9.23%
28/03/20135682.557.31%
31/03/20146704.2017.98%
31/03/20158491.0026.65%
31/03/20167738.40-8.86%
31/03/20179173.7518.55%
28/03/201810113.7010.25%
29/03/201911623.9014.93%
31/03/20208697.75-25.17%
31/03/202114690.7068.90%
31/03/202217464.7518.88%

Observations

(A) Stock market returns always get clumped. Over last 27 financial years.

  • Compounded Annual Growth Rate (CAGR) is 11.21%.
  • Positive Annual Return – 7 financial years of 23% or more – highest being 81%.
  • Negative Annual Return 6 financial years of 9% or more – highest being 36%.

(B) There could be long waiting periods before big moves come. Do not discount the likelihood of extended non-performance when planning your finances.

  • Nifty 50 went from base of 1000 on November 1995 to 978.20 on 31st March 2003 >>> 8 years & CAGR of (-) 0.30%.
  • Nifty 50 went from base of 8491 on 31st March 2015 to 8697.75 on 31st March 2020 >>> 5 years & CAGR of (+) 0.48%.

(C) Drawdown is the measure of the Nifty’s fall from an all-time high i.e., a fall of 5% from a peak is a 5% drawdown event. Historical data of Nifty 50 index suggests that

  • for 38% of total trading days, it remained 20% below its all-time high.
  • for 21% of the time, Nifty 50 index was in 30% drawdown territory.
  • in 2 out of 3 instances, 5% fall from the high point, went on to become a 15% one.
  • in 1 out of 4 cases, 5% drawdown developed into a 30% fall from peak.
  • in 1 out of 2 cases, 15% drawdown extended its losses to 30%.

Given that markets are exhibiting great bullish fervor for over a year now without support of strong economic growth, it would be prudent to remind oneself that stagnancy, negative to poor ‘inflation-adjusted returns’ & deep drawdown are as much a fact of investment experience as have been a 11.21% CAGR of Nifty 50 index.

Stock Market history is replete with instances of a benchmark index peak going on to scale new highs. However, between the peaks could lie a deep valley &/or huge expanse of time, both of which could significantly pull down the compounded average. Re-balancing the asset allocation helps reduce downside investment risk as well as imposes discipline to investor behavior.

Bond ~ Equity ~ Currency ~ Commodity

Correlations between Asset Classes

Fungibility of money is central to the process of investing & wealth creation. It implies equal value between the assets & facilitates substitution of an asset class by another. The investor chooses an investment with most favorable risk-reward ratio but is free to substitute it with another when such ratio turns unfavorable. The primary investment options – commodity, bond, equity & currency – have deep correlations. Whatever happens in one asset class has an impact on fundamentals of other asset classes. The intermarket relationships assume critical importance for the investor, as he tries to figure out the big picture & assess the shifts in the direction for each asset class.

Bond

Reserve Bank of India (RBI) issues bond to finance government expenditure & the coupon rate at which it issues its 10-year paper, is the primary benchmark from which all interest rates in the economy are derived. Bond Yield is actual return if an investor was to buy bond from the market. It is calculated as % of interest earned by investor (interest rate % on face value) & bond market price. Bond price & bond yield move in opposing direction. There exists an inverse relationship between interest rate & yield.

Bond Yield is influenced by

  • Interest rate expectations – Important indicators are RBI’s view on the state of economy & real time data on economy.
  • Inflation Inflationary environment forces investor towards higher yield – to compensate for loss of purchasing power.
  • Economic Growth – Strong economic growth forces competition for capital, thereby pushing up the yields 

Equity is a riskier asset & risk needs to be compensated by a premium over & above interest rate in the economy (as derived from the most risk-free coupon rate of RBI).

Equity

Investment decisions are based on risk-return trade off. Equity is a riskier asset class than debt. If interest rate on FDs is 5% & expectation from equity is 9 to12%, then one would be more inclined to invest in equity, even if it means taking more risk.

As bond yields fall, equity becomes more attractive asset class. The reasons for fall are 3-fold. Firstly, due to shift in asset allocation from bonds to equity by aggressive investors. With more money flowing into equity market, stock prices rise further & investors get higher returns. Secondly, decline in interest rates result in lower borrowing costs for companies & an improvement in profit (EPS). Thirdly, companies take advantage of lower interest cost to fund capital expenditure & growth, thereby generating expectation of higher profits in future. The combined effect is higher demand & a fillip to equity valuations.

When yields start to rise, bonds become more attractive in a relative sense. As long as gap between expected equity return & bond yield does not get too narrow, there is no reason to shift asset allocation to bonds. Also, if interest rate is raised by RBI on account of demand side inflation (due to faster economic growth & higher per capita income), then companies have the power to pass inflation onto customers & protect (even improve) profits. In such case, equity remains the preferred option.

When bond yield keeps rising, an inflexion point is reached where risk free yield makes expected return from equity unworthy of the risk in it. At such point, investors begin shifting asset allocation from equity to bond. The resultant selling in stocks & demand for bonds leads to simultaneous fall in stock prices as well as bond yield. As stock prices fall, risk-averse investors begin shifting to bond to protect their capital, causing stock prices to fall further along with fall in bond yields.

Eventually, stock prices would have fallen so much that expected reward from equity starts looking attractive vis-à-vis bond yields. The shift in asset allocation to equity begins all over again.

Currency

Exchange rate vis-à-vis Reserve Currency (US Dollar) impacts fund flows to & from all markets. Commodities are directly impacted by depreciating or appreciating currency. Imports in depreciating currency environment translates into higher inflation & cost of production. Rise in CPI inflation forces RBI to hike repo rates – the most important factor effecting bond yields.

Foreign institutional investors (FII) want dollar (USD) returns. US Treasury Bond Yield is the reference point for investment decisions of FIIs. ‘Interest rate differential’ with Gilt bond yield, net of expected currency depreciation would be the key parameter. Inflows & outflows of USD would impact the exchange rate.

If US Treasury Bond yield rise & the INR depreciates versus USD, then risk-reward ratio for Indian equity vs. US Treasury bond’ gets less favorable. FII flows into / from equity market impact our bond yields indirectly through the foreign exchange rate.

Commodity

As commodity prices rise, the cost of goods moves upward & the price increase gets passed onto the consumer.

The inflationary impact of commodity price rise is further accentuated by currency depreciation, in case the commodity has to be imported. For example, India’s 80% oil demand is met through imports & depreciation of INR visa-vis USD tops up the inflationary impact of oil price rise. Inflation ultimately gets reflected in interest rates.

Intermarket Relationships

All the four markets operate together but there is always a time lag between each of the market reactions. Also, several factors may come into play during such time lag. An understanding of positive & inverse correlation among the markets, provides important confirmation of developing trends & warnings of potential reversal.

If commodities are rising, bonds have started to fall & shares are still on the rise, then the inter-relationships would eventually force a retreat in stocks at some point. It is just a warning of a reversal for stocks. A confirmation that correlations are taking over would only come when share price goes below major support levels & moving averages.

At times, intermarket relationships break down. The above correlations assume an inflationary economic environment. However, in a deflationary environment, share prices go down on account of poor growth prospects but bond prices will move up to reflect lower interest rates. Despite the economic environment, one market may not respond at all due to shifting global dynamics, like financial liquidity, politics etc.