Step 3: Understanding expected average return or why investment duration matters.
You will notice that I’ve been indicating a range of returns for each asset class. This is because not all investments within an asset class provide the same return or with the same level of certainty.
For some investments, the return is fixed and certain. For example: A savings account provides 4% interest and that doesn’t change very often. When it does, it remains fixed for a period.
For others, such as equities, the return may vary from day to day. The Expected return for these investments is therefore their long-term average return.
Within an asset class you may have a choice of both kinds of returns. For example: Savings accounts with a fixed 4% return or liquid funds with an expected average return of 5%.
For investments whose return varies with time, the period of time over which the average return holds true varies for each investment. In general, the period for which you need to hold an investment to get the expected average return increases with the return.
Liquid funds come close to their average with a few months, but for equities you must be prepared to hold for 7-8 years before you can expect a return close to the average.
The expected return and the duration cannot be separated without disastrous consequences. For example: you cannot expect to achieve the expected return of equities in a few months or the expected return of debt funds within a few days.
Why Equities are essential
Let’s revisit the post tax returns table. It’s quite clear that:
- Cash will lose you money over time;
- A tax efficient fixed income investment will help you preserve the value of your money; and
- You cannot shy away from Equities if your goal is to grow your wealth
At the same time, Equities are an asset class where the high expected average return is realized over a much longer period and with a great deal of variation in the interim.
The variability of stock market returns is the primary reason for the general feeling among investors that stocks are risky. This is not incorrect but reflects a lack of understanding of the asset class.
As an investor you must understand and embrace the fact that the value graph of your equity investments will roughly resemble a roller coaster but will ultimately result in significant growth of your wealth.
Why would anyone want to invest in fixed income?
A number of investors are so convinced by this argument that they take a step away from fixed income altogether and invest all their money in Equities. This, to paraphrase the warning on cigarette packs, could be injurious to your wealth
Evaluating all the options
The following table summarizes everything we’ve discussed above and provides a kind of ready reckoner. As I said earlier, all of them have a place in your life. The trick is to figure out which one works for you under which circumstances.
What do these percentages really mean?
The table below translates these percentages into hard numbers to provide a clearer understanding of where each of these investment options will get you over time.
How can you invest in the alternatives we’ve discussed above.
At Scripbox, we believe that mutual funds are the best option for investing in both equity and debt.
Keeping things simple with Scripbox
Scripbox is a packaged solution that makes it super simple to invest in mutual funds. We take care of the most difficult & time consuming tasks related to your investments:
- The research required to select the best mutual funds.
- Automated money transfers from your bank to mutual funds for your on-going investments
- Automated annual review & rebalancing
- Portfolio tracking & performance reporting
All you have to do is decide how much to invest.