A reader wants to know if he can expect “10% per annum” if the investment period is a “minimum of five years”. Again, regular readers of freefincal might dismiss this as a newbie mistake, but it is a common mistake and deserves some attention.
The first point to appreciate is unless we are investing in fixed-income instruments with a guaranteed return, there is no “per annum” return. In a capital market-linked instrument like mutual funds, we have no idea what the (final) returns will be, and they are computed in hindsight. That is at the end of the investment period. Therefore the thumb rule is to expect as low as possible.
Many investors try to compensate for their inability to invest more by taking on more risk assuming that it would fetch them higher rewards. This is a mistake. A higher risk only implies a higher risk. That is, the range of possible returns is higher, and we could end up with any return from a significant positive to a large negative value.
So how do we handle this uncertainty?
- Time. The longer the investment period, the better the chance of us managing the portfolio as per our needs and reducing this uncertainty. Some claim that the longer the investment period, the better the chances of getting a “good return”. This is incorrect. The uncertainty associated with the stock market never dies down! See: The stock market always moves up in the long term, but returns move up and down! If we do not manage risk systematically, we will leave the fate of our investments to luck.
- Asset allocation: The right mix of volatility (equity) and stability (fixed income) is essential. It is the simplest way to reduce return uncertainty. Yet most investors get this wrong. They either use too much equity for too short a time or too less equity for longer periods.
The asset allocation is primarily determined by the investment period. So to pull this off, we must be clear about when we need the money. Many investors first say they want to invest for five years, but when pressed about when they need the money, they say they can afford to invest for longer.
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This is why it is crucial to separate short-term goals from longer-term goals. If someone says they can invest for a minimum of five years, we can only offer recommendations for the five years.
A duration of five years is still a fairly short time. The return uncertainty is hard to minimise over this period. Therefore, we recommend avoiding all equity if the goal is crucial (needs). For flexible goals (wants), you can consider a conservative hybrid fund like Parag Parikh Conservative Hybrid Fund.
However, do not expect 10% returns! Do not expect any returns! Just invest as much as you can each month, and there is a reasonable chance of getting 7-8% (assuming this is the only fund and the risk is unmanaged).
Finally, avoid the lure of high-interest-rate fixed deposits or bonds. These come with credit risk; recovery is nearly impossible if they fail.