Investment Dilemma of My Friend

A few weeks back one of a good friend of mine, let’s name him Amit, approached me for some investment advice. At first, I felt honored to guide someone on their investment objectives. As we have been together from past more than 3 years I have had a fair idea about his risk profile. As per his risk profile, I did suggest him a fund to invest, but as fate would have it, few other good friends suggested him few aggressive funds to invest and at the end he was lost in the jungle of suggestions. Analysis Paralysis bug had bitten him. On following up after few days I was shocked to know that he decided to go with Recurring Deposits and discarded all suggestions. I could understand why he did so, he did not want to waste time as his investment objective was time-bound.

Investment Dilemma

Let’s understand his profile first before we deep dive in suggestions.

  • Age : 35. Moderate Risk Capacity.
  • Risk Tolerance : Low. He had burnt his fingers earlier in the stock market. I am assuming he had joined the market along with the crowd when it was riding high and he had left the market along with the crowd when the market was testing its low waters. Most investor (read traders) do that, not his fault.
  • Tax Slab : 30%
  • Monthly Investible Amount : 10,000/-
  • Investment Time : 3 Years. (Oct-2016 to Sep-2019)
  • Basic Requirement : Do not want to loose capital.
  • Preferred Investment : Recurring Deposit. His preference is ICICI, which is giving 7.25% annual interest at the time of writing.

Based on the above profile, I could understand that he is not willing to take many risks and he does not want to loose capital. He had a bad experience from the market but he still showed courage to try equity for 3 years investment objective is a good sign. I am assuming that irrespective of market conditions he will continue his SIP and as and when he has extra money to invest he will put Lump-sum. Please read SIP vs Lump-sum guide.

Many articles are referred for below analysis, but at a broader level below 3 material used.

  1. Tax Structure Table, prepared by Santosh Sharma from Mint.
  2. Compound Interest Calculator from Financial Calculators
  3. Rolling Return Calculator from Personal Finance Calculators

First and foremost, let me put up a disclaimer that below analysis is based on last 10 years returns from mutual funds. We have seen the 2008–09 recession, 2011 slowness and 2013 US Tapering impact on emerging countries like India. I firmly believe that next 3 years will have good returns due to growth-oriented government. But I can not be certain on that, as it’s market’s inherent nature of being volatile. Secondly, Funds chosen for analysis are for reference as they are good performer as of writing, any other substitute from the same category should also work same way. Lastly, Mutual Fund investments are subject to market risk, the famous disclaimer from advertisements.

Now, as I have covered myself :), lets deep dive in 3 investment choices I discussed with my friend.

Choice #1 : Recurring Deposit

First let’s analyze Amit’s preferred choice. He is having his savings account with ICICI hence it’s his preferred bank of choice. Several other banks seem to be giving marginally better rates as per Bank Bazar but let’s stick with his choice.

  • Rate of Interest : 7.25
  • Total Corpus prior Tax : 4,02,948
  • Interest Earned : 42,948
  • Tax : 12,884 (Interest Earned * 30%)
  • Actual Earned Interest post Tax : 5.075 (Rate of Interest * (100–30))
  • Net OnHand Corpus post Tax : 3,90,064

Post-tax treatment he is going to earn 5.075% interest, for the sake of better understanding lets round it to 5%. Now on, let’s consider this as the base rate. All of other investment choices should have potential to beat 5% post tax treatment.

Choice #2 : Income Fund (Debt Fund)

As explained on Types of Mutual Funds article, considering time frame is not so long Amit could opt for Short Term Debt Fund (one type of Income or Debt Fund). Debt funds carry a slightly higher risk compared to Bank’s deposits but it has potential for marginally higher returns in response to higher risk. As explained in “Risk-Return Tradeoff” article from Investopedia.

I have chosen HDFC Short Term Fund for analysis purpose. Feel free to substitute it with any other Short Term Fund.

Below is 3 years rolling returns of HDFC Short Term Fund since April 2006.

HDFC Short Term Fund 3 years rolling release since April 2006.

Historically it has delivered between 8% to 11% returns. Return Since Inception for fund is 8.10% as of writing this article. Out of 91 Data Points 39 times the fund has delivered more than 10%, and 60 times the fund has delivered more than 9%. From last around 3 years it has been delivering more than 10% annually, so it’s safe to assume that at minimum it’s going to deliver 9.5%.

  • Rate of Returns : 9.5
  • Total Corpus prior Tax : 4,15,314
  • Interest Earned : 55,314
  • Tax : 16,594 (Interest Earned * 30%) [Withdrawal before 3 years hence Slab Rate]
  • Exit Load : 945
  • Actual Earned Interest post Tax : 6.6+
  • Net OnHand Corpus post Tax : 3,97,775

More than 7k extra with same investments. Beats Recurring Deposit’s return and does not erode value much in compare to long term inflation of 7%.

Choise #3 : Balanced Fund

Last option I proposed is HDFC Balanced Fund, Amit could choose any other Balanced Fund. Considering Amit is having low Risk Tolerance I suggested Balanced Fund because such funds provide around 65+% Equity allocation and 30+% Debt allocation. No need to track Asset Allocation. I could have chosen pure Equity fund, but it would have been risky for him and he would not be able to digest volatility as per his risk tolerance.

Compared to earlier discussed options Balanced Fund is risky one, theoretically, it could reduce invested capital but practically it has not happened in last 10 years, except once but I am sure he is not that unlucky. :)

HDFC Balanced Fund 3 years rolling release since April 2006.

Historically it has delivered good returns. Its returns since inception is about 17% as of writing this article. Out of 91 data points 59 times it has given more than 15% returns and 76 times more than 10% returns. So earning more than 15% is high likely possible and if Amit turns out to be lucky he may get 30%. So for safer side lets take long-term average of fund 17% as a reference for calculation.

  • Rate of Returns : 17
  • Total Corpus prior Tax : 4,62,835
  • Interest Earned : 1,02,835
  • Tax : 1,666 [Last Year gain is taxed, remaining is tax free. First 2 years investment earns 3,32,049 as corpus. Last year’s earning is 10,786. As per tax table it’s taxed on 15.45%]
  • Exit Load : 1,307
  • Actual Earned Interest post Tax : around 17% (Such a low tax does not impact much)
  • Net OnHand Corpus post Tax : 4,59,862

Now let’s take little worse scenario. Let’s assume that Amit is unlucky and he got 9% returns only. The probability of getting lesser returns than this is very less, only 12 out of 91 data points since April 2006.

  • Rate of Returns : 9
  • Total Corpus prior Tax : 4,12,296
  • Interest Earned : 52,296
  • Tax : 892 [Last Year gain is taxed, remaining is tax-free. First 2 years investment earns 2,86,522 as a corpus. Last year’s earning is 5,774. As per tax table it’s taxed on 15.45%]
  • Exit Load : 1,257
  • Actual Earned Interest post Tax : around 9% (Such a low tax does not impact much)
  • Net OnHand Corpus post Tax : 4,10,147

As we can see Balanced Fund is very Tax Friendly. Most likely, Tax outgo will not be more than 3k even in best case scenarios.

Big returns of 17% gives 69k more compared to Recurring Deposit, and modest return of 9% returns beats it by 20k. Even 7% scenario beats Debt Fund post tax, forget about Recurring Deposit. I have not considered best case scenarios of 25% to 30%, as those numbers will be mind boggling. :) Good for Amit. But I think above numbers are closure to realistic.

So, let me summarize these three choices. Recurring Deposit performed worst in comparison to both of the other options. Short Term Fund is good option if your Risk Tolerance is low, it will give you little extra boost compared to Recurring Deposit. Balanced Fund is risky option out of all, but as per Risk Return Tradeoff it has high potential to beat both of the other investment choices. Losing capital is theoretically possible but it has only occurred once, so practically his capital is safe with depreciation, inflation is not considered here to make it simple to understand.

I am sure, it’s not only Amit’s time bound goal for which this article could be helpful but anyone who is having fear about Equity based investments could start with Balanced Fund and once he/she start understanding how it works and improves his/her Risk Tolerance he/she can venture into pure Equity investments.

Direct Stock is also a good idea but it requires time and skills as discussed on another post of mine, and there are several advantages which Mutual Fund offers as discussed on another post here.

So, advice for Amit. Ignore Equity investment only if you do not have stomach to digest volatility. Equity has potential for high returns.

Enjoy!


Originally published at The Simple Personal Finance.