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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Choose Wisely

Posted by Muthu on December 27, 2014

Morgan Housel mentions the below 2 points in this wonderful piece:

“1) Remember what Wharton professor Jeremy Siegel says: “You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds [after inflation]. So which is the riskier asset?”

2) In finance textbooks, “risk” is defined as short-term volatility. In the real world, risk is earning low returns, which is often caused by trying to avoid short-term volatility. ”

As you are aware, for last few years, every April, we publish a comparative chart of performance of various asset classes from 1979-80 to till date.

Between 1979-80 to 2013-14; for the last 35 years; fixed deposits have produced an annualised return of 8.41% and Sensex 16.72% (18.72%, assuming a dividend yield of 2%).

Let us assume, 35 years ago, you invested Rs.1 lakh each in FD & Sensex. As on March 31’st 2014, FD is worth Rs.16.94 lakhs and Sensex is worth Rs.2.23 crores.

Before we feel happy about the above returns, we’ve to understand that the average inflation rate for the above period is 7.57%.

Real rate of return = Nominal returns – Inflation

So the real rate of return for FD is meagre 0.84% and for Sensex is 9.15% (around 11% including dividend yield).

So your investment of Rs.1 lakh in both FD and Sensex, 35 years ago, after adjusting for inflation, is ‘really’ worth as follows: FD- Rs.1.07 lakhs and Sensex- Rs.14.20 lakhs.

Since FDs are taxed every year on accruals, you would not have even got the real return of 0.84% and would be sitting on a negative return. Your Rs.1 lakh investment would be even lesser than the capital value. Whereas Sensex, even after inflation, has multiplied your wealth by 14 times. There is no tax on long term capital gain.

Though it looks FD has multiplied your wealth by 17 times, in terms of purchasing power, it has actually eroded your capital.

Even Sensex, though it appears to have multiplied your wealth by 223 times, has actually done so ‘only’ by 14 times, if you take purchasing power into account.

Many people, especially with real estate and gold, have no clue about annualised return, inflation adjusted return, impact of transactional cost and taxes etc. What we think as what we are earning and what we are actually earning are not one and the same.

The real risk is not the short term volatility you see the in stock markets. The real risk is capital erosion, due to returns eaten away by inflation and taxes. So for all long term requirements, you need to invest in instruments which beat the inflation handsomely and are also tax efficient.

In the above example, equities have beaten inflation by around 9% and also given that return absolutely tax free. What more one can ask for?

So please understand that risk is not short term volatility but long term erosion of capital.

Fixed deposits are not volatile but they erode capital and reduce your purchasing power. Equities are volatile but they multiply capital and increase your purchasing power.

Choose wisely for long run.

One Response to “Choose Wisely”

  1. Your posts over the past couple of days have been exactly what I have been looking for. Hits the nail on the head in term of which is better from real returns point of view.

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