A study of the history of growth investments clearly reveals that there are only two avenues of such investment that have consistently beaten inflation over the long-term. These avenues are equity and real estate.

Section 1: Real estate and bullion

Bullion

Timothy Green, a well-known bullion expert, reminds us of a historical truth: “The great strength of gold throughout history has not been that you make money by holding it, but rather that you do not lose. That ought to remain its best credential.”  So gold can at the most preserve the value of your money over the long term.  In other words, gold investments can grow at a rate approximately equal to inflation. Investing in gold does not beat inflation.

Real estate

Investors who had invested in a good piece of real estate 20 or 30 years back would certainly have increased their wealth considerably in this period, even after discounting for inflation. That brings us to the question of whether an ordinary investor should invest in real estate.

Real estate suffers some serious drawbacks.

1. Poor liquidity. You can sell on the stock market instantly and get your money within three days or encash a mutual fund investment within a week. But you cannot sell real estate quickly and easily, even during boom time.
2. Difficulties and dangers in title verification. This is when you purchase real estate. There’s also the risk of black money component in such transactions.
3. Huge funds. You need large amounts even to purchase a single unit. Plus, you need to pay high stamp duties at the time of purchase. However, there’s no duty to be paid when purchasing equity shares.
4. Huge sum for additional purchases. Let’s assume you bought stocks and real estate worth Rs 30 lakhs each, and now want to make additional purchases since the markets have fallen. Your stocks and real estate are both valued at Rs 20 lakhs. You can buy additional stocks even if you have a lakh or two, but to buy additional real estate you’ll perhaps need at least another Rs 20 lakhs!
5. Cumbersome formalities. For both buying and selling of real estate.
6. Administrative efforts. Once you buy real estate, you’ll need someone to look after it. There could be problems associated with absentee landlordism, such as encroachment, squatting, deterioration of houses/ apartments because of keeping them locked up, etc.

By investing in a diversified portfolio of stocks, which includes stocks from the real estate sector, you can make real estate a part of a diversified equity portfolio. But you cannot do the opposite – you cannot make equity part of a real estate portfolio, because it would then cease to be a real estate portfolio, unless you went in solely for real estate-oriented stocks!

What should a common investor do?

If you are genuinely interested in real estate investment and have a talent for it, you won’t need much advice. But if you have neither the interest nor the talent, then here’s a thumb rule to stick to:

Buy real estate only if you have use for it – some of the best real estate consultants we know believe this.

• Everyone needs a dwelling place; so, own a house.
• If you run a business, apart from a house, you need office space. So, try to own both.
• If you manufacture and sell a product, you’ll need three units of real estate – a house, a manufacturing facility, and an office space to showcase and sell the product. Ideally, try to own all three. 

Section 2: Equity/ stock market investment

The world’s best experts on investment are unanimous in their opinion that equity is the best avenue of investment ever invented for long-term growth. The problem is equity can also be used for speculation. Day trading, margin trading, etc., are means of speculation and turn this magnificent avenue of investment into an avenue of gambling.

You can invest in the stock market in two ways:

• Direct equity
• Mutual funds

2.1 Direct equity/ equity investment model

To invest in direct equity, you need to open a trading and demat account with a stock broker. The second way of investing in equity is through mutual funds.

In 1988, we came out with a simple model for equity investment that any common investor could follow. It was based mainly on Benjamin Graham’s classic ‘The Intelligent Investor’, which is the only book on the stock market worth reading. Benjamin Graham was the teacher of Warren Buffett, who went on to become the world’s most famous and successful stock market investor.

Our model consists of six simple rules and one recommendation. Let us take the rules one by one.

1. Diversify across sectors. The most important investment technique ever invented isdiversification. We have tried to improve the quality of diversification by looking at it both from the point of view of industry sectors as well as companies.

The stock market is nothing but a reflection of the economy of a country. It factors in both current economic performance as well as future expectations of what is going to happen in the economy.

In the US, there are total stock market index mutual funds, which buy and hold all the stocks listed and traded on the stock market, in the ratio of their market capitalisation. A low-cost, total stock market index fund would be the best way for a normal investor to invest in the stock market.  In India however, such broad-based index funds do not exist.

Therefore, we looked at the Indian economy and found that productive economic activity is generated by three major segments: agriculture, manufacturing industry and services. Translating this to stock market investment would mean that you select stocks of companies present in all these three major segments.

2. Diversify across companies. Take a sampleof major companies from major sectors and build a portfolio spread across about 60 to 70companies and 20 to 25 sectors drawn from agriculture, manufacturing and services. We are also great believers in the concept of ‘economic impact’. We will explain this concept with 3 examples.

• Example 1:Around the year 2000, there was an all-India craze for shrimp farming, which was also called aquaculture. A number of farmers converted their paddy fields into shallow lakes where they did prawn farming. The Supreme Court then passed a judgment that such farms had an adverse impact on the environment and should therefore be shut down. Overnight, the farms had to shut down.  Thousands of entrepreneurs lost their money. Tens of thousands of workers lost their employment. There were hardly any protests, and aquaculture disappeared almost without a trace.

• Example 2:In 2001-2002, there were numerous leather tanning industries in and around Calcutta in West Bengal. In another judgment, the Supreme Court laid down that the chemicals from these leather tanneries were polluting certain rivers. The tanneries closed down, thousands of entrepreneurs lost their money, and tens of thousands of workers lost their jobs. Despite the fact that all this took place in the then communist ruled state of West Bengal, this industry disappeared without a whimper.

• Example 3:At more or less the same time, the same Supreme Court of India passed another judgment sharply raising the vehicle emission control standards in India and gave manufacturers very little time to comply with the new requirements. The profits of all vehicle manufacturers were hit badly. The automobile companies could convince the finance minister just how much revenue in terms of excise duties, sales tax and corporate income tax the government would lose, if major auto companies like Tata Motors, Mahindra & Mahindra, Maruti Udyog, Bajaj Auto and Hero Honda, ran into serious trouble.

When the failure of a major company or industrial group can have an impact on the revenue generation by the government and when this impact will be felt in the GDP growth of the country, it is called economic impact. The auto sector had economic impact. The prawn farmers and leather tanners did not have it. The government immediately amended certain laws, and gave more time for the Indian automobile sector to introduce emission controls in a phased manner, thereby circumventing the judgment of the Supreme Court.

3. Allocate equal amounts to all sectors. Once you have chosen the top sectors and the top companies, then as per the third rule of our model, spread your investments equally across companies in these sectors, without attempting to predict which sectors and companies will do well and which won’t. Such predictions have repeatedly proved to be useless.

4. Reinvest dividends. This is the fourth rule and a fairly simple one.

5. Review investments periodically. Make additional purchases only if there is a drop of 25% or more in the index from the day you started your initial investment, orfrom the last market peak. Do not churn the portfolio frequently and repeatedly.

6. Understand the time horizon. A time horizon is a time element attached to each avenue of investment, which if adhered to, eliminates risks and delivers optimum returns.Time horizons are based on the average time it takes for a boom and recession cycle to be completedin the stock market.  It’s usually five years.

The concept of time horizons is not confined to investments. In agriculture, paddy can be harvested after six to seven months of sowing; mango saplings will give meaningful yields only after five years or so. In real estate investments in India, the time horizon is 10 years. For equity, worldwide, the time horizon is five years.

The implication: money you put into equity should be money that you can afford to block for a minimum of five years. Similarly, money put into real estate should be money that can be blocked for at least 10 years. If not, you may be forced to sell in distress.

A time horizon is however, not a jail sentence. If by some chance you make a lot of money in the stock market in two or three years, and are satisfied with the results, you can book profits. If however, things go wrong, you can expect safety and returns over the time horizon.

Recommendation: systematic investment. This holds good for equity as well as equity mutual funds.  Decide a fixed amount to invest in the stock market every month and then stick to your monthly investment programme for at least five years.  The concept of systematic investment is very closely related to the risk management tool of diversification. Systematic or recurring investment is nothing but diversification across time. 

2.2 Mutual fund investments

Mutual funds are a hybrid way of investing in real estate, debt, commodity and equity markets.  Instead of investing directly, you pool resources with other investors and invest.

As in the case of stock market investments, a lot of wrong advice is given in mutual fund investments, too. Very often, terrible products like new fund offers (NFOs) are sold, not because they are good for investors, but because mutual fund distributors earn maximum brokerage from them.  Similarly, a lot of fads like sector funds are recommended, whereas the only two types of equity mutual funds worth investing are well diversified equity funds and index funds.

The six areas where we see value in mutual fund investments 

1. Emergency funding and short-term parking of funds

For this, we recommend the following:

• Liquid funds, when you are unsure about the duration of investment.In other words, a liquid fund is used as a glorified savings account and is generally recommended for investments of up to 3 months.

• Ashort-term fund, for investment between 6 months – 1 year.

• Ashort-term floating rate fund for investments up to a year. Especially when you are more or less sure that funds are not needed for the first month, but may be needed anytime thereafter.

• Aquarterly interval fixed maturity plan (FMP) when you are unsure of when the funds may be required, but are sure that they are not required for at least the next three months.

Liquid, short-term and short-term floating rate funds currently yield between 6.5% and 8% p.a.  Quarterly interval funds yield approximately 7.5% p.a.  These yields can change depending upon the state of the debt market from time to time.  None of the above funds have anything to do with the stock market.  They invest in the inter-bank call money market, short-term government bonds, short-term corporate loans, short-term financial institution loans, etc.

Non-resident Indians (NRIs) or Persons of Indian Origin (PIOs) can invest in mutual funds from their NRE accounts.  On withdrawing, the redemption proceeds get credited directly to the NRE accounts.  Investments in mutual funds can also be made on a non-repatriable basis, by investment from the NRO account.

2. Intermediate-term investment (1-3 years)

A mix of Fixed Maturity Plans  (FMPs) and arbitrage funds is the best bet for intermediate-term, risk-free investments.  FMPs of more than twelve months duration offer tax-efficiency for residents and higher returns for NRIs.

What are FMPs?

FMPs buy and hold a diversified portfolio of debt securities designed for redemption in line with the term of the plan. There is no trading in the securities held by FMPs. The yield on each security and the expenses of the plan are known in advance. Therefore, mutual funds are able to indicate what the yield is likely to be just before each plan closes for subscription.

The indicated yields are quite accurate. Generally, the variation is not more than 0.5% of the yield indicated on the last day the FMP is open for subscription. For instance, if an FMP indicates that you earn 9%, you could earn 8.5% or 9.5%.

If all this is confusing, think of mutual fund FMPs as the mutual fund equivalent of a cumulative bank deposit of more than 12 months duration.  FMPs do not invest in the stock market.  They invest in corporate and government bonds, and other debt instruments, and therefore are as safe as bank fixed deposits.

A few points to remember:

• Unlike NRE bank FDs, FMPs are not tax-free.They are subject to long-term capital gains tax deduction of 10.3%.  Now, let us assume a very low yield of just 8.25% per annum on FMPs of more than one year. So, after tax, you get a yield of 7.4% p.a. This is appreciably higher than the tax-free yield of 4.85% or so offered on NRE deposits.

• For non tax paying resident Indians, bank FDs may be better if at the time of investment, the bank FD rates are higher than the FMP indicated rates. This is also more or less true for residential investors in the 10.3% income-tax slab. But FMPs would be significantly better for resident tax payers in the 20.6%, 30.9% and 33.99% tax brackets.

• NRIs need to only compare the present NRE deposit rates with the indicative yield of intermediate-term FMPs, after deducting 10.3% from the indicative yield of FMPs.

Bank FD rates and FMP yields are dynamic. They change and constantly compete with each other.  However, the key factor in the investment decision is the post-tax rate of the FMP compared with other investment options, at the time of investment.  There are times when FMP rates were higher than domestic bank deposits.  Right now, BFDs average 9.25%for residents, and FMP rates are in the range of 8.25 to 8.5%.  But these rates are only the starting point of analysis.

We illustrate the above with an example.

• A resident Indian in the 30.9% tax bracket invests Rs 1 lakh in a 9% FMP of a year and a day.On maturity, he earns Rs 9,000. He pays capital gains tax at 10.3%, which amounts to Rs 927.

Net earning (in Rs):

9,000

-927

= 8,073

• On the same day as investing in the FMP, he also invests Rs 1 lakh in a bank fixed deposit, with a yield of 10% p.a. It’s a clear 1% more than the FMP. He earns Rs 10,000 as interest and pays tax of Rs 3,090 (being in the 30.9% tax bracket).

Net earning (in Rs):

10,000

-3,090

= 6,910

This net return of Rs 6,910 is significantly lower than what he gets from the FMP, that is, Rs 8,073. It is important to consider this while making an investment decision, and not merely compare the 10% bank fixed deposit rate with the 9% FMP yield.

In financial jargon, looking at the final yield net of taxes and expenses is called ‘looking at the bottomline’. It is also called the post-tax rate.  This is one of the best habits an investor can cultivate.

Here’s another example – an NRI invests Rs 1 lakh in an NRE bank deposit giving 4.85%.  There is no income tax on interest earned on these deposits.  So, he earns a tax-free amount of Rs 4,850.  If he invests the same in a 8.25% FMP of one year he earns Rs 8,250 upon maturity. The long-term capital gains tax at 10.3% is Rs 850.

Net return (in Rs)

8,250

–850

= Rs 7,400 (appreciably higher than Rs 4,850 from the ‘tax-free’ NRE bank FD).

Arbitrage funds

Arbitrage funds are another class of safe mutual funds. These funds carry on a business of buying shares in a market and selling them in another market where the prices are higher.  The deals are entered into in the two markets simultaneously and so there is no speculation or risk.

For example, if a particular stock is traded at Rs 600 in the Bombay Stock Exchange cash market and at Rs 606 in the National Stock Exchange 30-day futures market, the stock is bought on the BSE and sold on the NSE simultaneously.  If this position is settled after a month, the profits are Rs 6 on Rs 600 or about 1% per month or 12% per annum.

Some mutual funds specialise in such operations.  When there are no such opportunities, the funds are kept in safe debt instruments.  Returns on these funds have been between 7% and 9% per annum, for an investment horizon of a year or more.  An important point: arbitrage funds are considered ‘equity funds’. There is no tax whatsoever on profits made, provided the investment is held for at least a year.

Equity Linked Savings Schemes(ELSS)

ELSS investments are more relevant to Indian residents.  Section 80C of the Income Tax Act enables an investor to get a tax exemption of Rs 1 lakh, in addition to the basic exemption of:

• Rs 1.8 lakh for all male assesses
• Rs 1.9 lakhs for women
• Rs 2.5 lakhs for senior citizens (60 years and above)

Therefore, if a non-senior citizen woman earns Rs 15,000 salary per month and has no other income, she does not have to worry about tax, because her total income is Rs 1.8 lakhs, which is less than the basic exemption of Rs 1.9 lakhs.

Now, non-residents are not taxed in India on their foreign income. They are also not taxed on the interest they earn on NRE bank deposits.  However, Indian income tax laws assume very great importance when non-residents decide to return to India on permanent transfer of residence. Without proper tax planning, they may need to pay unnecessarily high taxes when they start filing income tax returns as resident Indians.

Therefore, our advise to NRI couples: both husband and wife must have individual NRE and NRO accounts.

• The husband must have an NRE account and an NRO account in both of which he is the first holder and his wife is the second holder.
• The wife must have an NRE account and an NRO account, in both of which she is the first holder and the husband is the second holder. This must be done even if only one of them is working and the other is not, as long as both of them live abroad.
• Before returning to India on permanent transfer of residence, the husband and wife must split their savings more or less equally between themselves and make two separate inward remittances to their respective NRE accounts, from abroad.

Let’s see how this works with the help of examples.

Example 1:

All investments are brought to India only in the husband’s name

The husband invests Rs 80 lakhs in resident bank deposits at 9.5% interest per annum.

He earns Rs 7.60 lakhs of income

He will pay tax as described below:

• On the 1^st Rs 1.8 lakh – nil
• On the next Rs 3.2 at 10.3% – Rs 32,960
• On the next Rs 2.6 lakh at 20.6% – Rs 53,560
• Total tax payable on the income of Rs 7.6 lakhs = Rs 86,520

Example 2: 

Husband and wife split their savings and transfer them to India in equal proportions

Each of them invests Rs 40 lakhs in 9.5% bank fixed deposits; each of them earns Rs 3,80,000.

The total family income is the same as in example 1 – Rs 7,60,000 lakhs – but is earned by two individual income tax assesses equally.

The tax paid by the husband will be:

• On the 1st Rs 1.8 lakh – nil
• On the next Rs 2 lakhs at 10.3%– Rs 20,600
• Total tax payable by the husband = Rs 20,600

The tax paid by the wife will be:

• On the 1st Rs 1.9 lakhs – nil
• On the next Rs 1.9 lakhs at 10.3% – Rs 19,570
• Total tax payable by the wife = Rs 19,570

The total tax payable by husband and wife will be Rs 40,170. Compare this with Rs 86,520 that the husband would have to pay, if they had not equally split the inward remittance of their savings.

Example 3: 

This is the same as example 2, but we now assume that from the earnings of Rs 3,80,000 each, they also invest in instruments like ELSS, which give them a further exemption of Rs 1 lakh each.

In this case, the tax that each of them pays will be as follows:
By the husband:

• On thefirst Rs 2.8 lakhs – nil
• On the next Rs 1 lakh at 10.3% – Rs 10,300
• Total tax payable = Rs 10,300

By the wife:

• On the 1st Rs 2.9 lakhs – nil
• On the next Rs 90,000 at 10.3% – Rs 9,270
• Total tax payable by the wife = Rs 9,270

Therefore, on a total family income of Rs 7.60 lakhs, the total tax is only Rs 19,570. This is an example of tax planning, which is only a small part of financial planning.

Numerous avenues offer eligibility under Section 80C, the best among them are ELSS and the Public Provident Fund (PPF).  Non-resident Indians cannot open PPF accounts. Anybody can invest in ELSS.  Non-resident Indians may require tax saving under Section 80C, in case their Indian income exceeds the basic exemption limit prescribed from time to time.

For example, if a non-resident Indian owns an apartment in Bangalore from which he earns rent of Rs 25,000 per month, his total Indian income will be Rs 3 lakhs, far higher than the present basic exemption of Rs 1.8 lakhs. Such a person will definitely need tax saving avenues like ELSS.  With its good long-term earnings potential, limited risk and tax saving features, ELSS schemes constitute the third area of mutual fund investment in which we see value. 

4. Systematic investment, especially into equity and balanced mutual funds

Systematic investment lets you invest fixed or varying sums of money in one or more avenues of investment at regular intervals.  This definition is quite flexible on both the amounts to be invested as well as the avenues of investment. The rigidity is in ‘at regular intervals’. This is because systematic investment aims to make investing a habit.

We are used to poor quality systematic investment plans such as recurring deposits into post office or bank recurring deposits. Actually, the greatest benefit of systematic investment is felt when it is made in investments whose values fluctuate.

Here’s an example of the difference between what a normal stock market investor does and how the same strategy would look in systematic investment.

Let’s assume you are a good stock market investor. You do not speculate, you do the minimum required studying, invest in good stocks and do not panic when the stock markets falls.

• You identify a stock, currently quoting Rs 100 per share in the market. You purchase 100 shares, paying Rs 10,000 for them. Unfortunately, the market falls heavily and in three months, the stock is quoting Rs 70 per share.

• You do not panic.You examine the new situation and find that at Rs 70, the company’s shares are a bargain. So you buy another 100 shares, investing Rs 7,000 this time. Unfortunately, the country’s economy is going through recession and three years later, the same stock is quoting at a miserable Rs 40 per share.

• You neither panic nor buy again blindly. As a shareholder of the company for a little over three years, you’ve been receiving and examining the company’s annual reports and financial statements. The company is still making profits and paying some dividends. You reason that if this company can keep its neck above the water in bad times, it should certainly do very well when the next boom occurs. So you purchase a third lot of 100 shares, paying Rs 4,000 for them.

The summary of your investments:

• Purchased 100 shares at Rs 100 per share, investing Rs 10,000
• Purchased 100 shares at Rs 70 per share, investing Rs 7,000
• Purchased 100 shares at Rs 40 per share, investing Rs 4,000

In total, you’ve purchased 300 shares for a total consideration of Rs 21,000 or an average price of Rs 70 per share.

Now let us convert the above example into systematic investment. In normal stock market investment, the investor’s focus is generally on quantities or numbers of shares to be bought or sold.  In systematic investment however, the focus is not on quantities, but on equal amounts at regular intervals.  In the above example, Rs 21,000 has been invested in three transactions. To convert that operation into systematic investment, divide Rs 21,000 into three equal portions of Rs 7,000 each.

The rest of the example is the same. You invest:

• Rs 7,000 first when the stock price is Rs 100 and get 70 shares
• Rs 7,000 next when the stock price is Rs 70 and get 100 shares
• Rs 7,000 again when the stock price is Rs 40 and get 175 shares

You have 70 + 100 + 175 = 345 shares for the same Rs 21,000 as opposed to 300 shares through the normal investment made in the earlier example.

In the systematic investment, you end up holding 345 shares at an average price of approximately Rs 61 per share, against 300 shares at Rs 70 per share in lump sum investment. This is not magic; this is simple mathematics.

By shifting your focus from a specified quantity of shares to be purchased per transaction, to investing equal amounts at regular intervals, you automatically tend to buy a lesser number of shares when the market is high and a greater number of shares when the market is low. This helps you obtain a favourable weighted average instead of a neutral simple average, as in the first example.

When we buy the same stock or the same kind of investment (for example a particular diversified mutual fund), at different times, we have a high price at which we purchase the stock or units and a low price. The median point between the high and the low price will be the simple average. For example, in the first case of normal stock market investment, the high price was Rs 100, the low price was Rs 40. The mid-point between these two prices or the simple average was Rs 70.  The prices changed, but our quantities remained the same.

However, by using the superior technique of systematic investment, you end up with an actual price of Rs 61, which is below the simple average. In short, you achieve better pricing, by an automatic process, without relying upon research and deep study. Systematic investment always and without exception enables you to get a final purchase price that is below the simple average price of the high and low rates during the period you made the investment.  Here prices changed, and the quantities purchased also changed in response to the price change.

To sum up, systematic investment plans (SIPs) in mutual funds are useful because:

1. They enable even asmall investor with modest means to make systematic investments with amounts as low as Rs 500 or Rs 1,000 per month.

2. They afford convenience andease of operations in making the investment.  You can give standing instructions to your bank that a certain amount must be systematically invested every month into a certain mutual fund investment plan.

3. Even with very small amounts, you can achieve diversification across all major sectors and stocks. For example, three of the best diversified equity funds in India which invest in the main, large, blue chip companies are the Franklin India Bluechip Fund (from Franklin Templeton Mutual Fund), the HDFC Top 200 (from HDFC Mutual Fund), and the Fidelity Equity Fund (from Fidelity Mutual Fund).  One of the best diversified mutual funds which invests in mid and small capital companies is the Sundaram Select Midcap Fund (from Sundaram Mutual Fund). At any given time, the above funds would be investing in something like 30, 50, 80, and 100 stocks respectively. Now, if a small investor is placing even Rs 500 per month in the HDFC Top 200 through a systematic investment plan, each purchase of this Rs 500 enables investment in the average of 50 companies that the fund is holding. Such a facility can be obtained only through mutual fund investment.

4. You have heard of diversification across sectors and companies. Systematic investment enables such diversification and also performs another very important function.It enables diversification to be complete as systematic investment is diversification across time.
5. Systematic investment automatically enables right pricing.
6. Systematic investment makes investment a habit.

   We conclude this note on systematic investment, by tackling the most important aspect of therisk involved in systematic investment into fluctuating avenues like index or diversified equity funds.  Investment in diversified equity funds carries a risk in the short-term. Equity investment is however safe in the long-run. Systematic investment certainly does not eliminate risk, but reduces it quite significantly.

The maximum risks in equity indices almost never exceed 50%.  In quality portfolios such as the ones recommended in our paper on equity investment, the risk is generally not more than 35%.  But in systematic investment, the risk does not exceed 25%, 17%, and 10% in the first, second and third years.

Let’s look at an example.

• If you make a systematic investment of Rs 1,000 per month into a diversified equity fund, and have completed 12 months during which there has been a massive fall in the stock market, your maximum risk will not exceed 25% of the total of Rs 12,000 that you have invested. 25% of Rs 12,000, that is Rs 3,000 can be the maximum depletion in your investment.

• In two years, you would have invested Rs 24,000. 17% percent of this is approximately Rs 4,000. This can be your maximum risk in an SIP in two years time, in the worst-case stock market scenario.

• In three years, you would have invested Rs 36,000. The maximum risk will not exceed 10% or Rs 4,000 approximately.

Ever since the modern era of the Indian stock markets began in 1979, we have not seen any risk in SIPs of more than three years.  Once you start, however, it is good to continue an SIP for at least the equity time horizon of five years.

5. Systematic transfer plans

The ‘zero risk systematic transfer plan’ is an asset allocation strategy and addresses a key issue that investors face: risk in equity investments.

Many investors shy away from equity investments because of the risk involved. What they don’t realize is that the stock markets have a history of slightly more than 400 years. During this period, not a single stock market system of any country has ever collapsed. On the other hand during the same period, countless banks, including some of the best banks in the world, have gone under.

The risk in the stock market is only in the short-term. History has shown repeatedly that there is absolutely no risk in equity investments in the long-term, especially in a well diversified portfolio of even reasonably good stocks.

What if a stock market investor is given an opportunity to invest in equity without the accompanying risk? We came across many studies worldwide, which established that using an asset allocation strategy, which combined both, debt and equity investments, risk could be fine-tuned to the level desired by the investor.

You will understand this better with a simple example.  Assume that Rs 1,00,000 is invested in a safe avenue of investment, which gives a return of 5% p.a.  Now, 1% of this principal or Rs 1,000 per month is transferred to a reasonably well diversified bunch of stocks.  If such a strategy is put in place, there will be no risk to the investor’s capital, regardless of the state of the stock market over any period of time.

Using this strategy therefore, an investor can participate in the market without taking a risk to his capital. The systematic transfer plan (STP) combines all the benefits of systematic investment, and in addition makes use of the asset class of debt, which is non-correlated to equity.  Non-correlated means that equity and debt will generally not move together, where their returns are concerned. Short-term debt, which is the safest form of debt, will give low and steady returns. Equity can move up or down in the short-term, but gives higher returns in the long-term.

The rationale behind an STP can be explained in the following table:

Asset class	short-term (<5 years)	long term (>5 years)
Short-term debt	Safe	Safe
Diversified equity	Risky	Safe

What you see above is that debt is safe whether in the short-term or the long-term. Equity is safe in the long-term, but can be quite risky in the short-term. Therefore, the table shows 3 areas of safety and one area of risk.

The systematic transfer plan attempts to avoid this one area of risk by placing the corpus available (in our example Rs 1,00,000) in a short-term debt fund and systematically transferring 1% of this corpus per month to an avenue of investment that is safe in the long-term, namely equity.  While debt is also safe in the long-term, it should be borne in mind that equity gives far higher returns than debt, in the long-term.

Investing in an asset allocation strategy whereby a corpus is placed in a safe debt avenue of investment, and 1% of the corpus per month is transferred to a diversified equity avenue, is called a ‘zero risk systematic transfer plan.’

Risk can be of two types.

• Risk to capital. If you have invested Rs 1 lakh in equity and after one year, your investment is worth Rs 90,000, it is an example of risk to capital.
• Risk to return. If you have invested Rs 1 lakh in a zero-risk STP strategy and another Rs 1 lakh in a resident bank deposit, compare the two after one year. Assume that the stock market performs very badly and your STP strategy is worth Rs 1.03 lakhs. Your bank deposit has earned you 9% p.a. and is worth Rs 1.09 lakhs. If you argue that you earned lesser returns of Rs 6,000 in the STP strategy, the extent to which you earned lesser returns than a competing avenue of investment, isyour risk to return.

Do note that:

• This is just an example to illustrate the point. An STP strategy involving debt and equity is totally different from a pure debt investment like a bank deposit.
• Over a period of five years or more, STP strategies have repeatedly proved to bring higher returns than mostother avenues of investment, without taking a risk to capital.
• Hence to earn higher returns in the long run, it is worth taking a risk to return. First time investors in the stockmarket would certainly do well to avoid a risk to capital at all costs.

There are many risk-averse investors who do not mind a short-term risk to return, if they can be compensated by long-term returns, which will beat almost all other avenues.  Their main fear is of a risk to capital, not a risk to return.  We fully support any investor who does not want to take a risk to capital.  As Warren Buffett put it so beautifully: “The first rule of investing is: do not lose.  And the second rule is: do not forget the first rule.  And that’s all the rules there are.”

The zero risk STP has one other outstanding feature. At any time during the period of your investment, if the stock market falls by more than 25% from its last peak and remains below this level for at least a month, then we advise you to double your monthly systematic transfer from Rs 1,000 to Rs 2,000. Generally, you get a chance to do this at least once in a period of five years.  If you do avail of this opportunity, it can substantially enhance your returns.

As things stand in India at present, zero risk systematic transfer strategies are designed to quadruple your money in a period of 10 years, even if you do not get an opportunity to double your systematic transfer when the markets fall by 25% from their peak. If you do, the returns will of course be higher.

Viewed from any angle, the zero risk STP remains one of the best strategies in mutual fund investment. Its value lies in the following:

• Enabling a risk-averse investor to invest in the stock market without taking a risk to capital.
• Protecting the capital without compromising on returns.
• Usually providing an opportunity to substantially increase the returns when the markets descend 25% or more from their last peak.

6. Investments

A mutual fund is a common pool of money to which investors contribute, for investment in accordance with a stated objective. Therefore, mutual funds are not limited only to financial assets such as equity shares, government bonds, corporate bonds and other debt instruments. Mutual fund plans can also be formulated to invest in real estate, bullion, other precious metals, derivatives and so on.

When we study the history of investments, we find that where long-term, investment-beating and wealth-enhancing returns are concerned, the only two worthwhile avenues of investment are equity and real estate. Since real estate requires a lot of capital and considerable expertise, real estate mutual funds can offer a good alternative for investment. Similarly, there are certain asset allocation funds, which rebalance between various types of assets on a periodical basis.

For example we can have a fund that follows Benjamin Graham’s 50:50 rebalancing strategy.

• To understand this strategy, let us assume that the mutual fund has a corpus of Rs 2 lakhs.
• Rs 1 lakh is invested in say the Nifty Index and the other Rs 1 lakh is invested in a liquid fund, thereby maintaining a 50:50 balance between debt and equity.
• Let us say sixmonths down the line, the debt component has grown to Rs 1.04 lakhs and the equity component has grown to Rs 1.10 lakhs.
• The total portfolio value is now Rs 2.14 lakhs.
• To maintain a 50:50 balance now, there should be Rs 1.07 lakhs in debt and Rs 1.07 lakhs in equity.
• So, the fund now shifts Rs 3,000 from equity to debt, in order to realign itself to the 50:50 balance.

Such a fund would certainly be worth investing in, especially if it has a regular programme for rebalancing its portfolios at fixed intervals of say six months or a year. Regular rebalancing is perhaps the finest way of investing. It addresses all the normal questions that an investor has, such as when to invest, where to invest, when to book profits, what is the quantum of profits to be booked, etc.

To conclude, an investor should definitely consider real estate mutual funds and certain clear-cut asset allocation and rebalancing funds in the overall investment portfolio.