Mutual Funds- Compound Interest & Inflation
In this article, I intend to discuss equity mutual funds, it’s relation with compounding & inflation.
Refresher on Compound Interest
You would have likely heard of compound interest a few times, but a quick refresher here.
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Compound interest is basically “interest on interest” & over a long time period it has a big advantage over simple interest.
I will use the typical graph to show benefits of compound interest over simple interest:
“But, what has this got to do with equity mutual funds?” Good question.
Equity Mutual Funds & compound interest — any linkage?
Equity Mutual Funds have no interest component to it. Hence, equity mutual funds CAN’T compound. Infact, they can’t even provide simple interest.
However, everyone claims “equity mutual funds are a compounding asset”. Let’s look at equity mutual fund returns class over time, perhaps there is some compounding behavior.
I have picked Indian Index Fund based on Nifty 50 & <approx> plotted it’s annual returns. The Year-on-Year growth (or loss) % doesn’t look like compounding function.
Note: I have just taken the point to point returns from 1st Jan over the 1 year time periods as an approximate representation returns from the index. This approximation reduces the volatility of the fund, but does not impact the inference from the analysis.
Let me force-fit a compound interest curve here
WOW! Really looks like equity compounds right?
Hold on. Not so fast. Let me force-fit a simple interest curve & it’s associated compound interest here
So now, it looks like equity grows with Simple interest?
NO!! Simply force-fitting a curve on mutual fund returns does NOT mean that returns follows the equation. I can force-fit any random function, such as polynomial, logarithm, exponential etc, doesn’t mean that returns follows that curve.
Equity has no interest component to it. Hence, equity has no compound interest benefit (or simple interest benefit).
To be clear, I am not against equity mutual funds, I am against labelling them as a compounding instrument. They are a volatile instrument that can help stave off inflation over the long term, it may even offer growth benefits (with variability). But does it compound? HELL NO!
The compounding fallacy
Compounding is the most abused term in the financial industry.
Heck, even beyond financial industry, all kinds of gurus, misuse the word compounding.
Any non-linear benefit, such as snowball effect, interaction effect, butterfly effect etc, are often mis-labelled as compounding.
Metrics for Evaluation & Comparison
Inflation compounds. Inflation has an year-on year variability, but the nature of inflation has similarities with compounding.
The primary goal of investing is to match (& hopefully beat) inflation. (Ravages of inflation discussed here.)
As inflation compounds (many debt instruments compound too), for evaluation & comparison convenience, equity can be measured with compounding formulas & metrics such as CAGR, IRR, XIRR etc. This is merely for mathematical convenience, this doesn't change the fact that equity mutual funds don’t compound.
Equity Mutual Funds vs Inflation
I intend to cover some real statistics on India equity returns vs Inflation.
I will confess here, finding good quality data for precise calculations is quite difficult. Moreover, due to Harshad Mehta scam, data before the year 2000 isn’t very reliable. That implies the number of data points are low so inferences can’t be confident.
Let’s make do with the statistics we have.
From the stats in my last blog, approx 15 year government reported inflation is ~7%.
I have used data from advisorkhoj website, to fetch 15 year rolling returns for Nifty 50 Index fund.
Looks like the returns are in the range of 10–20%. Some detailed stats are available in the same website.
Let’s take 2 scenarios:
- Best scenario: 19.3% returns. After Inflation adjustment: 12.3%
- Worst scenario: 10.6% returns. After Inflation adjustment: 3.6%
Thus, inflation adjusted equity returns ranges from 3.6% to 12.3%. This is an overestimate.
Above stats miss out on 3 major aspects:
- Taxation: Equity (currently) has 10% long term taxation. So, ~1% of returns are lost.
- Mutual Fund Expense Ratio: ~1–2% of returns lost. Also, tracking error.
- Real Inflation: Inflation of 7% is merely based on official reported inflation. Reported inflation is much lower than inflation readers would practically come across. Reported inflation is a measure of the increase in prices of a standard basket. It doesn’t take care of any premium service that we use & premium services command a much higher inflation rate. Although significant, I am ignoring the impact of this is ignored as it is difficult to quantify & largely depends on our lifestyles.
Assuming an underestimate of 2 % for the above costs, cost adjusted equity returns varies from 1.6% to 10.3%.
Pretty neat! The returns from equity after adjusting for inflation are quite good & beats typical debt instruments.
Equity Mutual Funds have good (variable) growth benefits over inflation!
The long term prospect of Equity Mutual Funds over inflation makes them more attractive than most other investment options!
Wait. I am not done yet. This was merely equity returns. How about portfolio returns? Let’s look into that.
Real Portfolio Returns
Surely, one won’t have a 100% equity portfolio. Assume, an investors portfolio is 60% equity instruments & 40% debt instruments. Further, debt instruments inherently have low returns (with respect to inflation) & are taxed quite drastically in India. For debt instruments, I am assuming 0% returns after taxation & over inflation. (Even 0% is an overestimate if one holds FDs. But let’s do with 0%.)
So, portfolio returns depend on equity portion & equity returns. Thus,
Total Portfolio returns with Worst Equity scenario: 60%*1.6%=0.96%
Total Portfolio returns with Best Equity scenario: 60%*10.3%=6.1%
So, Total portfolio returns vary from (0.96% to 6%)
Total Portfolio returns are in low single digit range after accounting for inflation & taxation!!
Of course, these are approximate statistics & real world will vary. But these are sane ball-parks.
Also, these portfolio returns results are without even considering real inflation rate & assuming investors have high 60% exposure to equity! Practically, so many things can go wrong. 1–2 bad investment decisions. Sudden high-cost emergencies. Any of these, would easily drop portfolio returns to negative easily.
Honestly, portfolio returns stats are humbling & shocking! Everyone assumes they are growing richer by the day. The truth is far away from that.
The essential reason for money management is NOT to grow rich, rather to save oneself from inflation!!
To grow rich one needs to have high income & high savings (i.e. low lifestyle expense.)
Conclusion- Two Major Takeaways from the blog
Equity Funds do not have any interest (compound/simple).
Even though equity doesn’t compound. Equity may help stave off inflation over the long term!
When one accounts for inflation & taxation:
Total Portfolio returns are going to be low/non-existent over the long term.
Hopefully real portfolio stats puts in perspective typical old sayings. “Live in moderation.” “Don’t spend too much.” Don’t fly too high. or as Mumbaikers say “zyada udane ka nahi!” ’
I will take a quote from Morgan Housel, the author of my favorite book Psychology of Money.
“Golden Rule of Personal Finance: Live humbly & be patient. That’s like 90% of Personal Finance. That is it. If you can actually do this, you are a legend in Finance.”
Disclosure: Everything I write on personal finance is how I personally view/understand personal finance. However, everything I know on personal finance is 100% from the internet. While most concepts I mention are ubiquitous, some concepts & blogs are so wonderful they deserve a shoutout. I first came across the fact that equity does not compound in freefincal blog. You may read it here.
