A FASCINATING drama on investing – In 3 scenes

If there is only one post that you are ever going to read on EveryFin, then this should probably be it. It is worth its weight in gold. We are taught how to work hard to make money, but most of us were never really taught how to make money work harder for us. This post will give you the insights and the intuition you need to successfully invest your money. Please share it with your parents, children, siblings, friends and family – because everybody needs to know this.

And before you start, a piece of caution – Please do not jump out and buy or sell any assets discussed here after reading this post. It is only meant to ignite your thought process, so mull over it.

It is the year 2010. You have made your new year resolution that you are going to save and invest money for the future. 10 years later, how did your investments fare? Retrospectively, what should you have done differently?

Scene 1

Let us assume that you had Rs.1 Lakh saved up on the 1st of January 2010. There are 3 people you are taking advice from.

  • Your dad – Who says, “Beta, put it all in fixed deposit at SBI. That is the best way to secure your future.”
  • Your mum – Who says, “Putthar, you must buy gold. Rekha aunty’s son bought a lot of gold 10 years ago and its value has gone through the roof now.”
  • Prashant Jain, Chief Investment Officer, HDFC – Who says, “You should invest in the HDFC top 100 mutual fund. Our RSI indicator suggests that there is deep value in the market right now, stocks are making a come back…(and some more unintelligible financial terms)”.

A decade later, who was right? This graph has more.

Turns out, mum was right. Isn’t she always? If you’d invested everything in gold in 2010, your money would have gone up by a factor of 2.77X. The equivalent figures for mutual fund and FD are 2.45X and 2.18X respectively. But in some sense, they were all right. Saving and investing your money creates wealth. There is no denying that.

Our resolve – We will save, we will invest.

Scene 2

Let’s go back to the 1st of January 2010. You decide instead, that on the 1st of every month, you will take Rs.10,000 out of your salary and invest it (This is the crux of a SIP – Systematic investment plan. You take some money out every month and invest it). But where are you going to invest it? You go back to the same three people and they give you the same advice. Your mum says “buy gold”, your dad says “put it in FD” and Prashant Jain says something about the stock markets using Greek alphabets – Alpha, Beta type of thing.

So how did they do? Unsurprisingly, not very different from scene 1.

The red line at the bottom, is the cumulative total amount you have taken out of your salary and invested. There are a few things of interest on this graph.

  1. Notice that in almost any market condition, your portfolio value is higher than your invested capital (the red line)? This may not always be true, but over long periods of time it usually is.
  2. Also, did you observe the gap between the red line and the other three lines? This gap represents the profit you have earned on your invested capital. At the beginning you can hardly see a gap, but it grows wider and wider as time goes by.

This is what is known as compounding, the 8th wonder of the world that we were never told about. Over long periods of time, your cats give birth to kittens, they become cats and give birth to more kittens and those kittens become cats themselves and…you get the idea.

Our resolve – We will save, we will invest, and we will let it stay invested for LONG periods of time.

Scene 3

Bear with me, this is going to get slightly complicated. But we will get through this together. There is a concept in finance called “drawdown”.

  • Imagine you invest Rs.100 to buy 1 stock of Reliance on day 1.
  • On day 2, stock price goes up to Rs.130.
  • On day 3, stock price comes down to Rs.110.

Did you make a loss? No, the portfolio value of 110 is still higher than your initial investment of 100. But the portfolio value has come down from the peak of 130 to 110. This is drawdown, the reduction in value of your portfolio from the peak value that it reached expressed in % terms. And in this case your portfolio has suffered a 15.4% drawdown (20/130). Clear?

Next time somebody tells you about an investment opportunity, ask them what its maximum drawdown was in the last 5 years – You’ll be the coolest person in the room 🙂 

With this new knowledge, let’s go back and investigate the drawdowns that each of the three investments suffered over the 10 years period when you kept investing Rs.10,000 each month. Fixed deposit by definition is a safe asset and suffers NO drawdown. Its value goes only one way and that is up.

Now observe the drawdown chart of the mutual fund only portfolio. It lost almost 40% from its peak value when COVID-19 started spreading. Notice also how it has recovered rather quickly every time in the last decade.

What about gold then? Below is the drawdown chart for gold. Observe how its value has remained below its peak value for a long period of time?  

This is because the price of gold hit a peak in 2011 and never really recovered its value till late 2019. This price chart should make it clearer.

Let us go back to early 2010 again. You have listened to all the arguments about investing in stocks, gold and FD.

  • Stocks are risky, but typically have higher returns in the long run.
  • Gold typically earns a lower return but provides protection during times of high inflation and heightened uncertainty.
  • FD is totally safe, but usually makes the lowest return.

Suddenly, you remember your art class from primary school. Your art teacher said to you that primary colours red, blue and yellow combine to form other colours. Red and blue become purple, blue and yellow become green and so on. So it occurs to you that it must be possible to combine these individual asset classes in order to create a hybrid/blended portfolio that inherits some of the parents’ characteristics – high return (stocks), no drawdown (FD) and protection against uncertainty (gold). Ah, you are clever!

So instead of investing all the 10,000 rupees each month into only one of MF or gold or FD, you put 50% of it in mutual fund, 25% in gold and 25% in fixed deposits. 10 years on, how did that go? This chart below has the details.

All staggering sums of money for an investment of just Rs.10,000 per month. But notice how your decision has landed you the second spot on the table? You have done better than Prashant Jain, the CIO of HDFC asset management company! Not just that, look at the drawdown on your portfolio.

And now compare it with the drawdowns of the MF or Gold only portfolio. Let us stack the graphs together to get a better perspective. From left to right, drawdowns on the blended portfolio, mutual fund and gold respectively.

When COVID-19 started spreading in march 2020, your blended portfolio suffered a drop in value of less than 20% against the MF only portfolio that suffered a 40% reduction in value from peak. You did not lose sleep nearly as much as Prashant Jain did. This, my friends, is what is known as asset class diversification. And the benefit it brings to us – is reasonably high returns at moderate drawdown/volatility.

Our resolve – We will save, we will invest, we will let it stay invested for long periods of time and we will diversify our investments across asset classes.

Q&A

If you are already exhausted, please feel free to drop off and get a glass of water. You have earned it for getting this far. But there are some questions that need answering.

Question 1 – Surely Prashant Jain is smarter than us? Why didn’t he follow this trick?

The answer to that question is in 2 parts.

1) The outcome of any retrospective analysis done on investment returns like this always depends on the point-in-time it is done at. Imagine we’d looked at this data in Jan 2020, pre-COVID – The mutual fund only investment had done far better at that time (Our portfolio has not done too bad; it still took the second spot). You can scroll back up to the third graph from here to confirm.

2) Mutual fund managers are given specific mandate within which they manage their fund. The HDFC top 100 MF is a large cap only fund. Their objective is not to achieve maximum returns, their only objectives are to stick to the investment mandate and do better than the benchmark they have defined for themselves. That’s it.

Question 2 – If gold has done so well over the last decade, why don’t we put 100% of our investments into gold?

This question again can be answered in two parts.

A) – History is not a representation of the future. Nobody has a clue what will happen in the next decade.

B) – Gold has its own proponents and opponents. The generally accepted view is that over very long periods of time, gold earns a return equal to the rate of inflation and no more.

But gold provides an important diversification benefit. When stocks come crashing down, the value of gold goes up. Why? People take money out of stocks and rush to safe assets – like Gold, Yen, Swiss Franc. So it should form a part of everyone’s portfolio.

Question 3 – Fixed deposits are only just lagging behind other investment avenues. Why take pain in investing in stocks?

The average one year FD interest rate over the last decade was roughly about 7.5% per annum. Take out TDS of 10% on the interest, 4% average annual inflation over the last decade, we have earned a real return of just 2.75%. There is more – Given today’s outlook, it is safe to say that those days of 7.5% FD interest rate are behind us. SBI’s current one year FD interest rate is 5.1% per annum. I’ll let you do that math.

Share this post

Share on facebook
Share on twitter
Share on linkedin
Share on pinterest
Share on email