THE other day we got a query from a client
of ours who was disappointed with five-year SIP returns of equity funds that
are published in a personal finance magazine. This client of ours had pulled up
the table that listed SIP returns of all equity funds and had observed that
there were some which had 5 year returns as low as 12% per annum and some others
had returns in the range of 14-15% per annum.
The “safe” returns that one gets nowadays
means one’s money becomes approx.one-and-a-half times in 5 years. In contrast
15% a year corresponds to doubling one’s money in 5 years. Is it possible to be
disappointed by 15% a year over five years? Well, it is possible to be
disappointed by almost anything in this world, as you will no doubt recall from
those childhood occasions when your parents would see your exam marks. It all
depends on where you set your expectations.
However, we’re not blaming anyone who has
unrealistic expectations from equity returns. The fault actually lies with the
History of high inflation and high nominal returns that India has, coupled with
the general difficulty in doing mental math involving compounding returns. How
do inflation and past high rates affect how we think about investment rates?
For one almost everyone remembers a time when it was possible to get 10% a year
from a bank fixed deposit. Older people may even remember getting 12% or more
in PPF. Now a days, the highest interest
rates between 7 and 8% are the norm, with the upper end of that range already
being quite rare.
What is the difference between 10% a year
and 7% a year? With the routine number sense that most people have the
difference is 3%. And yet it is actually much more. The number
10 is 43% more than 7. The amount you earn at 10% in a year is 43% more than what you earn at 7%. Then comes the compounding. Over 5 years 10% a
year earns you roughly 52% more (one and a half times) than what 7% would
To people who are familiar with the basic
arithmetic of saving and investing all this is trivial stuff, self-evident and
hardly worth mentioning. And yet it’s far from self-evident to the vast
majority of savers. They feel that an equity mutual fund’s SIP return of 15% is
roughly speaking in the same range as bank FD’s because they feel that FD rates
are around 8 and used to be 10 at some point. These illusions are in a direct
way a byproduct of high inflation and high interest rates. If you adjust for 6%
inflation, then the bank FD got you 1% and as SIP in a middling equity fund 9%.
You should try the above calculations now.
This demonetization how high inflation and
nominally high interest rates create the illusion that fixed-income assets like
bank and other deposits are investments. In reality they are not. They can
barely preserve the value of your money There are many who have lakhs lying in savings accounts. This
money is nothing but a donation to the bank. Savings’ accounts are the most
misnamed financial products in INDIA as there has never been a time when they
had interest rates even remotely near the inflation rate. Again, people let
money in accounts because a 4 or 5% number looks like something. There is no
solution to this except to be aware of it and not let big numbers trick you.
The first step towards real and useful financial literacy is to be aware of
inflation and compounding and always look at investments after mentally
adjusting for these. It is not difficult and there are few things that are
useful.
