THE ILLUSIONS OF HIGH RETURNS

 

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.