Those of us who invest, usually have growth on our minds. But why do we want our money to grow? The most obvious answer that jumps out is that what you invest should become “more”.
It’s not just the “more” we are seeking, we want this growth as quickly as we believe is good. This is where returns come in. Higher the returns on an investment, the faster your money grows. We feel quite happy when we see our equity investments give double digits in a year. The next year we feel outraged when we see returns in the negative. This see-saw makes us question how to even look at returns.
We believe you need to know before you invest why exactly do you need the returns. The answer to this question will decide what to invest in and your baseline return expectation from that investment.
Why you and I need returns?
Simply put, the primary reason why you need returns is to make sure what you save doesn’t lose its value. It should also grow at a rate that is greater than, or at least equal to, inflation.
In the short term (less than 5 years), the growth of our money is generally a function of our salary or income growth which in turn depends on other factors. Some of these are under our control and some not. You definitely have greater control over these “returns” than any financial market will provide.
In the long term though (10 years or more), your savings are impacted the most by inflation. To guard against that you need to put your money, and faith, in something that has a chance to beat inflation.
That something is the Indian economy in this case. One thing is for certain. Despite whatever is happening right now, the economy and the companies in it have the best chance of growing fast enough to beat the increase in prices of commodities. History shows that.
That something is the Indian economy in this case. One thing is for certain. Despite whatever is happening right now, the economy and the companies in it have the best chance of growing fast enough to beat the increase in prices of commodities. History shows that.
The Sensex (which is a good proxy for Indian companies) has grown by a CAGR of roughly 12%-13% over the past 19 years. Inflation (CPI) on the other hand has been 5% or lower in the recent past.
In the past two decades inflation in India has varied but rarely crossed the 15% mark (the highest). Considering long term inflation has been in the 7%-8% range, equity returns, as measured by the Sensex, have beaten inflation by a sufficient margin.
Since most fixed income instruments depend on the interest rates decided by factors governed by the Central Bank (RBI), the returns for FDs and other debt instruments tend to be one or two percentage points above inflation and track it. Considering how interest income is taxed, you often end up earning less than inflation. The chart below shows how liquid funds have done versus inflation to give you an idea of what FDs (pre-tax) and the like would have achieved.
What all this means is that the returns you seek need to primarily achieve two basic things.
1. If you are looking to accumulate wealth or finance big goals like retirement or your child’s college education, returns should be above inflation.
This is subject to how much the most accessible and liquid asset class that has a history of beating inflation has returned. Beating inflation doesn’t happen overnight (unless you love to gamble) as it takes at least 7-10 years for equity to deliver inflation beating returns.
2. They should be what your final corpus amount needs considering how much you can invest and for how long.
The risk you are willing to consider in pursuit of returns should keep in mind the above. As many investors find out, a rate of return becomes less assured the more return they expect or want. We know for a fact that equity has beaten inflation in the past. Other asset classes like gold and real estate have also done this occasionally but tend to have their own issues.
To sum up
Returns must be based on reality and data, rather than just what we “desire”. If we have a lakh to invest every year and expect to accumulate a crore in five years, then we better open a business with that money and hope it really takes off because that is the only way we can generate a CAGR of 80% plus, in a best case scenario.
You must also look at your time frame. In the short term, safety of your savings matters more and thus only look at fixed income based investments like an FD or debt funds. Consider inflation beating asset classes only if you are willing to wait for 7-10 years and have a significant goal in mind. Finally, try your best to have a goal for your investments because without a goal, any rate of return can look bad.
#TakeCharge series
This 15 part series helps you identify and complete a single task every day for 15 days to take charge of your financial life. Over these 15 tasks, you will know more about your money and how to make it work harder while having to do less work and also worry less.
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