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Should I expect lower returns from equity in future?

The re-introduction of equity LTCG tax offers not only a chance to clean up our portfolios, but also recognise an important fact: returns from equity may gradually decrease in the next decade or so. No, I am not talking about tax eating away our returns. There are two reasons for this, – one positive and one not so much. We will consider the positive reason in this post.

Yes, the equity LTCG tax (assuming it stays at 10% for a few years) will reduce returns by at least 1% as shown in this study: Equity LTCG Taxation: How much tax do I need to pay? Illustration part 1. So I will now expect 9% from equity (instead of 10%). As explained below, this also means fixed income returns will come down, to about 6-7% after LTCG tax. With that, let us get tax out of the way and consider some history.

In December 2002, the Report of the Task Force on Direct Taxes by a committee chaired by Dr. Vijay L. Kelkar then Advisor to Minister of Finance & Company Affairs was published. Here is a quote.

Our proposals completely eliminate the dividend tax, and long-term capital
gains tax on listed equities in the hands of the investors. These have been recommended with the express purpose of reducing the exorbitant cost of equity capital in our country. These gains or benefits accrue entirely to individual shareholders.

As a result, from Oct. 1st, 2004, Equity LTCG was freed from tax, until it was changed on Feb 1st, 2018 (with effect from March 31st, 2018).

What is the cost of equity capital?  It is the return that an equity investor seeks in proportion to the risk that she takes for investing. If the return from investing in a stock is not significantly higher than (1) a risk-free bond and (2) the market itself, there is no incentive to invest in it. The same is also true of the market in general.

According to this survey, the cost of equity in India is about 15% (mid-2017). This is pretty high. So if you think, the government’s decision to reintroduce Equity LTCG tax is unfair or premature, it would be fair from the view point of high cost of equity. As mentioned in The Economic Survey 2017-2018, the government has sensed a shift in capital from fixed income to equity and therefore a loss of tax revenue.

It is perhaps premature because most first-time equity investors have less than zero understanding of volatility and are not likely to invest in 2018 as much as they did in 2017. Anyway, it is what it is.

In 2002, the cost of capital should have been at least 15%* as interest rates were high – although they had witnessed a sharp fall – see the evolution of Public Provident Fund (PPF) Interest Rates. The main difference is, retail participation was insignificant then.

* It should have been much higher as the 90s were a turbulent period as the govt recovered from near-bankruptcy and had to open the economy in exchange for IMF aid

When will our cost of equity come down? It depends on a lot of ifs!

IF long-term inflation in India is down to 4-5%. Then the risk-free return will fall close to that (meaning fixed income will be less rewarding). Then the cost of borrowing will also fall. So will the cost of equity or the expected return for the risk taken (the risk will not change!)

Unfortunately, inflation in India is a tricky multi-factored issue. If the currency is stable, if oil prices are stable, if monsoons do not fail often, if fiscal deficit is low, then we have a fair chance of inflation staying low. Most people will laugh or criticise me if I say this, but I will, since I don’t care: we must disclose all income and pay taxes properly to help keep fiscal deficient and inflation in check. Everything is connected.

Inflation has been low for the last couple of years, but the bank NPAs rocked the stability of the big lender. Banks are not healthy enough to lend at low rates. Again if businesses borrow at a high rate, they have to generate that much more profit to satisfy stakeholders.

I have said it before, I will say it again, we urgently need tax saving corporate debt funds. If we can mobilize retail money into these bonds, it could help lower the cost of capital over a decade or so.

Even though the situation does not look rosy as on date, I think the stage is set for lower inflation and lower cost of equity. This will not affect us in any way because if inflation is lower, then the real return required to beat it will also come down.

While expecting only 2% higher return on equity compared to fixed income (both before tax), will keep us calmer*, in time, it may soon reflect reality once the bank recapitalization and restructuring is completed and PSU disinvestment is in place. The next ten years should be a reasonable guess and it does not matter who comes to power.

* those who can manage to invest more. The rest will have to lower their aspirations.

The era of high interest fixed income is already coming to an end. Small saving scheme rates are now market linked. EPF now invests in equity. Higher income newer employees will not receive EPS pension. NPS is already the biggest mutual fund AMC in the country and growing at the corporate level. Regardless of when the cost of equity decreases with the next few years, at least for higher income group, the only market linked fixed income would make sense. And that is the first step towards lowering the cost of equity.

Unfortunately, those above 50 who have never invested in equity before are the most affected by this transition. They do not have the time to learn, get used to, and suffer the volatility of equity to enjoy the potential high return.

The second reason I mentioned in the first paragraph also has to do with “time”.  People talk about the Sensex zooming to 50,000 in future. It will, but our returns will depend on when it will. That is how long it would take to get there. More on this with examples in part 2 – Why “hodling to the moon” will not always work.

It is amusing and perhaps ironic that market volatility lowers equity returns (affecting the cost of equity) but without it, beating fixed income is impossible!

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Updated: February 13, 2018 — 10:19 am


  1. Pattu Sir

    Elephant in the room (or shall I say elephants) is/are

    1. Wasteful expenditure by government on populist schemes. There are dime a dozen. I do not want to waste your precious webpage by listing them

    2. Uncontrolled borrowing by the government to sustain these wasteful expenditures

    3. Deficit spending by the government again upon wasteful expenditure.

    4. Unbridled corruption at all levels of govt. and in the institutions run by govt. NPAs of public sector banks are only a small portion of this. You can list power discoms, airlines, bsnl, mtnl etc. etc. here

    You see we have no control over these things. So me paying tax or you paying tax to control inflation is meaningless (apologies for being so harsh). You see, taking medicine makes sense only when the disease is going to be cured.

    1. populists schemes are necessary. Corruption exists everywhere. To be able to point fingers, we must first do our duty.

  2. Pattu sir,

    It is this portion of your post which prompted me to post the earlier comment

    “Unfortunately, inflation in India is a tricky multi-factored issue. If the currency is stable, if oil prices are stable, if monsoons do not fail often, if fiscal deficit is low, then we have a fair chance of inflation staying low. Most people will laugh or criticise me if I say this, but I will, since I don’t care: we must disclose all income and pay taxes properly to help keep fiscal deficient and inflation in check. Everything is connected.”

    What I thought that you missed several important points which are some of the root causes for perennially high inflation and fiscal deficit in India. The factors mentioned in my comment will remain till the end of our lives. I do not care what happens thereafter!!!!!!!!

    Be practical. Either you beat them or you join them. There is no point in saying that “I will do my duty come whatever it may. I will be a saint and I will not see or I will ignore the sins of others.”. This sort of behaviour will only encourage the malice, which I have highlighted in my earlier comment. Sense of duty towards nation is good. But sense of duty which aids thieves and immoral is equally bad.

    1. I am no saint, but I will do my duty come what may.

  3. A very convenient and self-serving argument against paying taxes – since we have control over nothing including ourselves, let us all behave as savages !

  4. Excellent article Professor, as always.

    I have asked this question before, perhaps you missed. Don’t you believe in the Indian Growth story? that India is going to flourish in the years to come and Indian Equity will give the same, if not more? I would really love to know your answer Professor as I am enthusiastic about Equity.

    I do understand and will remember that the return expectation has come down from 10% to 9%.

  5. “Either you beat them or you join them.”
    Easiest and convenient excuse to justify anything. Reminds me of a tv episode I saw on TV where after a gang bust, a lady who hangs out with the gang pleads with the detective that she is not like them. And the detective answers – “Lady! You are them” 🙂

  6. I plan to invest RS. 5000 for my future and children education. Long term upto 20 years.

    Please suggest.. my calculations are right or wrong.. if any correction please made sir.

    1. ₹1000 in SBI blue chip fund through sip.
    2. ₹1000 in Reliance small cap fund through sip.
    3. ₹1000 in Brila sun Life frontline equity fund.
    4. ₹1000 in PPF
    5. ₹1000 in Sukanya Samruddhi account.

    1. Sorry, I don’t provide investment advice.

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