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Your Investments Need To Compound

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Your Investments Need To Compound
Prateek Mehta - 12 August 2020

The current state of financial markets and economy has had many equity investors panicking. To preserve assets and investments, many people are moving to safe havens. The safety and security of capital takes precedence; hence traditional investment options such as fixed deposits and government sponsored small savings schemes seem to be the right alternative.

However, once you get beyond the anxiety, you will realise that by moving funds to these fixed income instruments you would actually be doing a disservice to your hard earned money. Here’s why.

Return on debt dials down

SBI FD rate for one year is down to 5.1 per cent. Returns on fixed deposits have come down across the board. Small savings schemes such as Public Provident Fund (PPF) and National Savings Certificate (NSC) have shrunk from an average of 8 per cent (on an annualised basis) to a measly 5.4 per cent and 7 per cent respectively (before tax), as of May 2020.

Conversely, the general inflation (Consumer Price Index) is estimated around 5.84 per cent, while the food inflation is up to 9.28 per cent and medical inflation continues to hover around 7.2 per cent.

What this means in real terms is that the ‘purchasing power’ of your money, in effect is actually negative. This can be especially worrisome if these investments are aligned towards long-term goals such as buying a house, saving for retirement, or your child’s education.

While the deposits work fine as a parking spot for your savings, they will not be able to drive you to your financial goals at this rate.

Gear up to equity

Undoubtedly, equity markets have gone through a roller coaster ride this year. From an all-time high of 42,274 earlier in the year, the Sensex tanked to a 52-week low of 25,638 in March. As economic activity came to a standstill and corporate earnings turned red, businesses were forced to quickly adapt and pivot their strategies. The Rs 20 lakh crore stimulus package announced by the government and easing of the monetary policy by the RBI have provided just the spur Corporate India needed.

Since then, the index has recovered by 42 per cent as it touched the 36,000 mark as of July 2020. Of course, we are not out of the woods yet, and the volatility will continue to persist for the next two-three quarters at least. It is important to understand that the pain because of COVID-related slowdown might continue for a while before the real economy bounces back. However, for a long-term investor, this is an important time to keep investing and keep adding to their long term equity investments.

Historically, markets have always managed to bounce back stronger after a major downturn. During the 2008 financial crisis, investors who panicked and redeemed their investments booked an average loss of 48% on their capital, while those who continued to remain invested had almost tripled their money over the next 10 years!

Leverage the power of compounding

Stay invested in debt instruments such as fixed deposits, debt funds and other small savings schemes only for near-term goals or for your emergency corpus. For an investment horizon greater than three to five years, you should consider equity-based products such as mutual funds. These troughs offer the perfect opportunity to invest at lower prices with larger gains over the long-term with compounding.

This is not the time to speculate. This is not the time to start direct stock investing, day trading or F&Os (Futures & Options). Unless you have absolute faith in your investing capabilities, professionally managed mutual funds are the best bet. Not only do the fund managers have a keen eye on the economic scenario, they also have strategies in place to manoeuvre a crisis.

There are hundreds of different mutual funds each with a specific investment style. You can create a diversified portfolio of mutual funds and allocate resources to different funds based on your investment objective, time horizon and risk appetite.

Diversified large cap funds and index based funds demonstrate the least volatility, and these funds also usually pay out the highest dividends as well. Opt for the growth option. It will allow you to take advantage of compounding and reinvest your gains to buy more units of the mutual fund.

Those who do not have the stomach for a high equity exposure can also opt for balanced funds that will deliver better yields than pure fixed income products over the long term.

The opportunity to invest in Equity Linked Savings Scheme (ELSS) should not be missed either. ELSS is a specific type of mutual fund that combines the advantage of tax saving along with equity-based investment. As per section 80C of the IT Act, a taxpayer can invest up to Rs 1.5 lakh a year in an ELSS and offset the investment as a deduction against their tax liability.

ELSS also has a mandatory three-year lock-in period. This provides enough time for the fund to stabilise and for impatient investors to hold back, before they take a call to hold or redeem the investment.

Finally, irrespective of your investment style, it is recommended to take a systematic approach to investing. Systematic investment options allow you to average your cost of purchase (Rupee Cost Averaging), which is especially beneficial during volatile times. You can also increase, decrease or pause your SIP investments depending on your financial situation. You can also invest via a Systematic Transfer Plan (STP) in case you have an investible surplus that you are planning to invest.

For any investment, consistent monthly investing via SIPs or Systematic Transfer plans is the best way to create wealth over the long term.

This new normal demands a shift in strategy towards investing. Just as in life, there is no straight path to financial success; hence, it is important to not get perturbed by periodic volatility. Remember, building wealth is a marathon, not a sprint. Invest with a long horizon. It is absolutely fine to get rich ‘slow.’

The author is Co-founder of Scripbox

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