Last Updated on December 29, 2021 at 5:49 pm
This was a question posed in Facebook Group, Asan Ideas For Wealth: “Say I have 100rs and I am a highly risk-averse Individual and want 8% return YoY in the current economy. What are the options available? My investment horizon is 5 years”. This answer to this interesting question involves essentials of risk and reward which requires some elaboration.
If someone says I do not want any kind of risk for a 10-year or 15-year investment, then we will have to caution them about visible risks and invisible risks and that they are only referring to visible risks (price fluctuation). Inflation is an invisible risk which can reduce our spending power considerably over ten or fifteen years. It is impossible to avoid risks over that long an investment tenure. Not appreciating this is the biggest risk of them all. See for example: How should I invest to get Rs. one lakh a month pension?
In the present case, the investor has a horizon of only five years. Therefore it is certainly reasonable to try and avoid both fluctuations in price (visible risk) and invisible risks like reinvestment risk and credit risks. However, the question is, can we eat the cake and hold it too? That is, can we expect a high return with zero risks?
We can answer this with a dismissive ‘no, we cannot’ or we can elucidate the problem for the benefit of new investors. We choose the latter option since once cannot write an article with the former!
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Let us first look at a rough schematic of how investment returns vary with visible investment risk. Invisible risks are typically qualitative and will have to be considered separately. The visible risk increases from left to right.
The green dot represents no visible risks. The red squares correspond to (relatively) high investment risk. As the risk increases, the possible return starts oscillating. This just means the gap between max possible return and min possible return widens (hence two red squares well separated).
For a 15-year investment horizon, a good chunk of our money should be invested at the red-square risk level since we need to exploit the potential high-return to combat inflation (more on this in a forthcoming article). For a 5-year investment horizon, the prudent choice is to stick to the green dot.
The green dot = guaranteed return free from visible and invisible risk. The obvious choices are:
- GOI bonds (5Y)
- RBI bonds (5Y)
- Post Office Time deposits (5Y)
At a second-tier are the deposits from the “too big to fail” banks like SBI, HDFC and ICICI etc. Beyond this, the invisible risks would kick in. If we consider fixed deposits from state-operated corporations, interest payout could be delayed due to governance issues. See for example Tamil Nadu Power Finance Fixed Deposits: Are you aware of risks?
If we consider AAA-rated corporate FDs or bonds, there is concentration risk: all eggs in one basket. The interest payout could be delayed, the company could get into trouble. Needless to say, the risk gets progressively higher for lower ratings (hence the higher rate).
If we consider overnight funds or liquid funds (even those investing in gilts), the concentration risk is significantly lowered but since the bonds are of much shorter tenure than the investment period (5Y), the rate at which the NAV moves up can suddenly slow down (or speed up) if newer bonds have lower (or higher) coupon rate. This is known as reinvestment risk.
If we choose a debt fund with an average portfolio maturity close to five years, the NAV will swing up and down due to interest rate risk. Credit risk will also be significantly higher. Many advisors are “trained” to suggest debt funds with bond tenure matching investment tenure and this is just awful. See: Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile
In short: you can run, but you cannot hide
Hang on. An RD or FD in SBI or post office is for all practical purposes risk-free and would give a return corresponding to the green dot above. So what is the problem? Where that green dot lies changes with time. For an economy that does not get into trouble and gradually becomes stronger, we can expect the green dot to move as shown below.
The return corresponding to the green dot will fluctuate up and down with inflation but over a period of time, it is expected to move down. This is an extremely complex multi-pronged problem and the above is a simplistic representation. Since we are only considering investment reward is should barely suffice for our purpose.
As the economy develops, government borrowing and debt will gradually come down (this too would occasionally spike such as the present time due to the lockdown). The credit rating of the govt will gradually increase. This is similar to a business that was borrowing much more than its revenue but gradually reduced overheads. Inflation becomes more controllable and the borrowing rate reduces.
In just the last decade the post office five-year term deposit dropped from 8.5% to 6.7%. Imagine a person who keeps auto-renewing their “safe” deposits without looking at interest rates only to wake up to reality suddenly. This is happening as we speak to scores of retirees who never took on visible risks when they were earning.
Perhaps due to increasing inflation, the five-year rates could head up to 8% briefly in the current economy but that would mean making it difficult for businesses to borrow. The central bank (RBI) has an extraordinarily difficult job: balance ground reality with political ambitions; balance saving among several others.
The point is, at the time of writing one cannot expect 8% even before tax without visible or invisible risks. This is a good thing! If rates are high, inflation would typically be high, businesses would get into trouble; The saver would either have lesser money to work with or worse be out of a job. We need to appreciate “safe returns” in a holistic manner. The visible reward is the return mentioned. When the visible reward is low, invisible rewards could often be higher (stable, developing economy). To access these invisible rewards one will have to accept visible risk as part of the game.
Suppose the investor is “okay” with “some risk”, what should they do? Can they, for example, consider Shriram Transport 5Y FD with 8% plus returns but AA+ stable rating?
Personally, I would not. If a business should offer this high a return and stay alive, their profit margins should be significant. Even in a booming economy, this is hard. Presently it will be a lot harder.
What then? I would consider a money market debt fund or an arbitrage fund (these are subject to market risks) and take my chances with the possibility of a tax-efficient return.
Those who value their sleep (often because they do not want to stay awake and educate themselves of risks) should stick to safe SBI or PO FDs/RDs. At the end of the day, the need is in just five years. Before you know it, the money would be gone. No need to overthink such short-term problems.
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