PPFAS Long Term Value Fund is advertised with a tagline: Only for “truly” long term investors! The funds scheme document states, “Investors should note that this scheme is suitable for investors who have an investment horizon of minimum 5 years”.
Unfortunately,this can give investors the wrong notion that ‘long term’ implies duration of 5 years and that a diversified equity fund like PPFAS LTVF is suitable for a goal 5 years away.
Recently someone in the Jagoinvestor forum stated that they had invested in HDFC Prudence for a goal about 5 years away. His investment was in the ‘red’ after a couple of years and he wanted to know if her will able to generate enough returns in the remaining years to meet his goal. The plain and simple answer is NO, unlikely.
Before we get to intermediate-term goals, let us ask a couple of questions.
How long is long term?
You will find many articles online that state there over a period of 15 years or so there is no chance of losing money in the stock market. So when it comes to equity investing, long term implies a period of 15 years. Although zero probability of money-loss is not that comforting after 15 years of investment, the result does make sense.
There is one other article which states long term is a minimum of 7 years, using probabilities of achieving certain target returns. I am not comfortable about this result as the odds of achieving low returns (even losing money) are still high enough (for me).
If we are dealing with an instrument that can be volatile, average returns make little sense without looking at the standard deviation – a measure of how individual values deviate from the mean. A standard deviation of 1% for an average return of 10%, implies that 68 times out of 100 an investor is likely to get a return between (10% – 1%) and (10% + 1%). That is within one standard deviation.
This definition haspractical use only when the standard deviation is much lower than the average! The average rolling return (CAGR) over a 7 year period is about 18%. The corresponding standard deviation is 11%. So 68% of the time returns can range from 7% to 29%. A huge variation! Personally I am not comfortable about this because there is a 30% chance that returns will be lower than 7%
Over a 15 year period the average rolling return is about 16% with a standard deviation of 5%. The corresponding variation is much lower. However one should note that it still is significant volatility.
Bottomline: As a crude thumb rule, I would like a standard deviation which is not more than half the value of the return (for example, a standard deviation of not more than 6% for a return of 12%). If we go by market history, this will happen only when the investment tenure is 10 years or more. More details about this analysis can be found here: Understanding the nature of stock market returns
How short isshort term?
This is a tougher question to answer! The first thing to do is recognise that the power of compounding is not significant for short durations. Here is another crude thumb rule. We knowshort term is going to be just a few years. So in this duration, we assume a moderate post-tax return of say about 5%. If we invest Rs. 100 for 3 years, we will get a sum which is 16% more than our investment (~ Rs. 116). If we invest for 4 years, we will get a sum which is 22% more than our investment.
The percentage difference between the maturity value and the investment value (16% for 3 years and 22% for 4 years) will rapidly increase with higher investment durations. So I set the duration corresponding to an approximate percentage difference of ~15% as short-term. So about 3 years.
Short term: less than or equal to 3 years.
Long term: more than 10 years.
Intermediate-term: Between 3- 10 years.
Priorities associated with short-term and long-term goals are easy to understand (More details here: The Contended Investor)
- Little or no fluctuations in returns to ensure no loss of capital.
- Instruments: FDs, RDs, liquid mutual funds or even arbitrage mutual funds
- Relatively large returns fluctuations necessary to get returns that can beat inflation.
- Instruments: Significant equity exposure with adequate debt component. With diversification within each asset class.
These are extreme situations. Hence it is easy to choose financial instruments for investment. The risk appetite of the investor is irrelevant while planning for these goals. What matters is the risk profile of the goal
The trouble with intermediate terms goals is that there is no clear cut idea about how much volatility (fluctuation in returns) the goal can stomach. Do we invest only in fixed income instruments like FD/RD? Or do we choose an aggressive balanced fund (like HDFC prudence) in the hope of making good tax-free returns?
If we don’t care about tax outgo and think of tax as the price to pay for guaranteed returns, then FD/RD is a fantastic choice. I would recommend it for all short term goals and important intermediate term goals.
If an investor is driven by greed and wants post-tax double digit returns then the price he/she pays is not only volatilitybut also extended periods of poor returns. If our goal is 5 years away and if the invested fund gives negative returns for even two of those 5 years, we are likely to fall short of our net return requirement.
What we need to recognise is that volatility is a much bigger price to pay than taxes.
We could consider (among other instruments) a debt oriented conservative funds like Reliance MIP for goals more than 3 years away. However is it maybe surprising to note that its standard deviation is pretty high!
|Reliance MIP (source: Morning Star India)|
This means that over a 5 year period return can be as high as 20% and as low as 3%! The cost of high returns is the possibility of pathetic returns!
Fixed maturity plans are a good bet for both intermediate and short term goals, provided we understand the nature of debt securities involved and associated risk.
Take the case of a debt fund like Templeton India Short-Term Income Growth. According to Morning Star, the average maturity period of its portfolio holding is about 2 years.
However, I would be cautious before using it for short term goals because its 3 year returns of 8.26% comes tagged with a standard deviation of 1.66%. So although volatility will be lower I must peg my return expectation carefully. For example one could expect a pre-tax return of 8.26% – 1.66% ~ 6%. Anything higher than this is possible but with a much lower probability.
Also the danger of a bond crash cannot be discounted. An income fund may take several months to recover from a bond crash. So it would be risky to choose it for a short term goal. The risk is lower for an intermediate term goal. However the crash could occur toward the end of the investment tenure and lower returns significantly (my NPS tier I returns is a good example of this)
For a short term goal, I can blindly invest in a FD/RD/liquid fund and be done with it. For a long term goal, I will choose good equity mutual funds to start with, choose my debt options and slowly diversify over course a few months. That is for these type of goals it is easy to identify instruments that match the risk profile of the goal.
This is not so easy for intermediate-term goals. The investors risk appetite plays an important role. Trouble is most investors seem to think they can stomach higher risk without understanding the full implications of choosing an instrument.
In a waythis issue highlights the importance of starting early for crucial goals like retirement and children’s education. We cannot simply afford to let these become intermediate-term goals!
What do you think?
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