Last Updated on July 5, 2021 at 9:59 am
We all know the reason for investing in ample amounts of equity for long-term goals. It is to beat inflation. Or, in other words, to get a return higher than what typical fixed income products offer – a good measure of realistic inflation in India for day to day expenses (services tend to have higher inflation). But what about short-term goals? How can we beat inflation for short-term goals? This article stems from a discussion in the Facebook group Asan Ideas for Wealth.
Trying to beat inflation with equity for long-term goals comes with a price to pay. Returns are not guaranteed. You cannot keep investing with some set return expectation. Most investors brush this aside as a disclaimer in small font, but this is how bad it can get: My retirement equity MF portfolio return is 2.75% after 12 years!
This uncertainty and constant turbulence is a price to pay for the possibility of beating inflation over the long term, not a guarantee. Is there an alternative? Yes, we need to invest a lot more for years and years to compensate for the guaranteed poor returns we would get from fixed income products.
As pointed out before, constant risk management with an asset allocation schedule is necessary to keep this volatility at bay: Do not expect returns from mutual fund SIPs! Do this instead! However, even the expert portfolio manager will need one indispensable element: time. Without enough time, it would be impossible to handle the losses.
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When it comes to short-term goals, it the same element we do not have! The demarcation between short-term, medium-term and long-term is as arbitrary as the demarcation between low-risk, medium risk and high-risk investments.
If, for goals 10 years or more away, an equity allocation of 50%-60% is reasonable, how much would we allocate for, say, a 7-year goal? 30-40%? Easier said than done! A 100% equity portfolio can erode in value up to 60%. So we much expect a portfolio with 30-40% equity to fall by at least 20%.
If this 20% fall occurs in the first couple of years, we might chance it and wait for a recovery. If it happens later, just the emotional strain would be hard to be bear. Even if we give ourselves unsubstantiated hope that we can pull this off, things get much harder if the duration is reduced.
For a five year goal (generally assumed to be the borderline between short and medium duration goals), how much equity can we include in the portfolio? For beginners, 0% equity is advisable. Even for someone experienced, there is not enough time to accommodate more than 10-20%.
How much difference would 10% or 20% of equity make to the overall portfolio return? We would be lucky if this portfolio can get close to the government-reported inflation after tax.
Does this mean we cannot beat inflation for short-term goals? Thankfully the impact of inflation over 5 years is much less than what it would be over 15 years. Something costing Rs. 1 lakh today would only cost about 1.5 lakh after 5 years at 8% inflation and Rs. 3.2 lakh after 15 years.
We can still aspire to beat it but not by trying to get more returns but with higher investment. This might seem undesirable but is better than taking on risk and failing with no time to manage it. We easily afford to plan short-term goals with negative real return (after-tax portfolio return < inflation) and compensate for it with a little extra investment.
Choosing a simple RD or FD or a money market fund or arbitrage fund (See Handpicked List of Mutual Funds July-Sep 2021 for recommendations) will set the post-tax return to 4-6% (depending on the tax slab), and this would automatically mean higher investments to offset the inflation of 6-12% depending on the goal.
You can take a small amount of risk with a dynamic asset allocation fund or even equity “savings” funds. Still, since the bulk of the portfolio is in safe fixed income (hopefully!), higher investment is inevitable. Conservative hybrid funds come with their own set of risks (credit and interest rate) plus higher taxation than equity-oriented funds.
Many investors assume this is sub-optimal and a bad deal and chase after all sorts of fancy options, particularly in debt. This is an unnecessary waste of time and emotions. Short term goals are just that. After a few years, they are out of your life. There is no need to take on excessive risk for these and break our heads about managing it. It is far easier to beat inflation by investing a bit more for short term goals and focus on long-term goals.
Taking investment risk is essential but knowing when not to take it and where not to take it is more essential.
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