Like in in the famous fable where the Tortoise wins the race against the fancied rabbit, in investments too the much maligned low risk investments may be better under conditions of market volatility, as compared to high risk investments. Slowly but surely the low risk investments can outperform the high risk investments, beat the inflation and to use the commonly used mutual fund manager’s term, low risk investments can also beat the index.

First we take a look at what financial advisors generally advice. Their advice is represented in the data given in the table below.

 

Table 1: The Professed SENSEX Returns compared with Low Risk (Bank) Investments
Year	Sensex Index (Close)	Sensex Index Returns	Portfolio Value at beginning of year (Rs.)	Withdrawals (Rs.)		Bank FD Rate	Portfolio at beginning of year (Rs.)	Withdrawals at end of year (Rs.)
1986	524.45	–	10,00,000.00	50,000.00		10.00%	10,00,000.00	50,000.00
1987	442.17	-15.69%	7,93,111.83	39,655.59		10.00%	10,50,000.00	52,500.00
1988	666.26	50.68%	11,55,402.17	57,770.11		10.00%	11,02,500.00	55,125.00
1989	778.64	16.87%	12,92,517.08	64,625.85		10.00%	11,57,625.00	57,881.25
1990	1,048.29	34.63%	16,75,501.46	83,775.07		11.00%	12,27,082.50	61,354.13
1991	1,908.85	82.09%	29,67,175.48	1,48,358.77		13.00%	13,25,249.10	66,262.46
1992	2,615.37	37.01%	39,17,053.25	1,95,852.66		11.00%	14,04,764.05	70,238.20
1993	3,346.06	27.94%	48,15,558.80	2,40,777.94		10.00%	14,75,002.25	73,750.11
1994	3,926.90	17.36%	54,10,710.04	2,70,535.50		11.00%	15,63,502.38	78,175.12
1995	3,110.49	-20.79%	40,15,277.60	2,00,763.88		13.00%	16,88,582.57	84,429.13
1996	3,085.20	-0.81%	37,81,867.30	1,89,093.36		12.75%	18,19,447.72	90,972.39
1997	3,658.98	18.60%	42,96,118.87	2,14,805.94		7.25%	18,60,385.30	93,019.26
1998	3,055.41	-16.50%	33,72,643.17	1,68,632.16		13.17%	20,12,378.78	1,00,618.94
1999	5,005.82	63.83%	53,56,925.67	2,67,846.28		4.84%	20,09,158.97	1,00,457.95
2000	3,972.12	-20.65%	39,82,876.20	1,99,143.81		4.02%	19,89,469.21	99,473.46
2001	3,262.33	-17.87%	30,72,020.33	1,53,601.02		3.77%	19,64,998.74	98,249.94
2002	3,377.28	3.52%	30,26,663.65	1,51,333.18		4.31%	19,51,440.25	97,572.01
2003	5,838.96	72.89%	50,81,448.22	2,54,072.41		3.81%	19,28,218.11	96,410.91
2004	6,602.69	13.08%	54,92,024.04	2,74,601.20		3.77%	19,04,501.03	95,225.05
2005	9,397.93	42.33%	75,42,463.88	3,77,123.19		4.25%	18,90,217.27	94,510.86
2006	13,786.91	46.70%	106,87,789.05	5,34,389.45		5.79%	19,05,149.99	95,257.50
2007	20,286.99	47.15%	151,92,344.79	7,59,617.24
2008	9,647.31	-52.45%	64,64,976.44	3,23,248.82
2009	17,464.81	81.03%	113,80,488.83	5,69,024.44
2010	20,509.09	17.43%	127,95,190.21	6,39,759.51

Sources: The SENSEX Index values are from BSE Historical Data available in the BSE Website, the bank fixed deposit rates are averaged for the year from data available on the RBI Website

Creating a WOW in the minds of investor

According to the calculations in the Table 1, had a person invested his or her retirement funds (say Rs. 10 lakhs) in a basket of shares identical to their representation in SENSEX and if the person withdraws 5 % of the fund value each year for living expenses (a variable pay pension, so to say), in 2010 the fund would have a value of Rs.1.27 crores! Not bad for someone who has invested only Rs10 lakhs. Individuals who do not accept this conclusion and do not park their retirement money in higher risk investments such as mutual funds are considered financially illiterate and old fashioned. You can listen to this in every talk show on TV and every second article in the newspapers on the subject of investment.

Let us take a closer look at the data in Table 1.

What about VOLATILITY?

OOPS, the advisors somehow forgot that.

You will notice that the SENSEX gave negative returns in 7 different years. The returns during the period mentioned in Table 1 varied from year to year, from a high rate of 81.03% to a low of -52.45 %. Such variations are called volatility of returns. The higher the volatility, the higher the risk. Volatility is the fluctuation of the share prices – the degree and the frequency of fluctuations in a given period. The risk in an investment is the volatility of returns. In other words at the time of investment one does not know whether one would earn 81.03 % or -52.45 % over a period of time. If one could predict even with a fair degree of accuracy, there would be no risk on that investment. Since we cannot predict the future returns with a fair degree of accuracy, we do not know whether we will get high returns or negative returns.

How do investors make money on the stock exchanges or mutual funds?

 It is the timing

In risky investments, the timing of the buying and selling is important. The ideal situation is to buy when the prices are at their lowest and sell when the prices are at the highest. But that is easier said than done. There are very few people who get the timing right. There are even fewer people who get the timing right consistently over a long period of time. Not getting the timing of buying and selling risky investments can result in huge investment losses, which in retirement may become unbearable.

Volatility also results in some investors earning a lot of money, while others lose theirs. To which category you will belong is only a conjecture. And it is very risky for a retiree to gamble on this conjecture. In investments there is no free lunch and there is no tree on which money is stacked where you have to just go and pluck. If an advisor says that you can earn a lot of money on a particular investment, the rate he quotes as the possible rate of return tells you about the degree of risk more than the return. The higher the rate quoted, the higher the risk.

The bank interest also changes year to year, and is to that extent volatile. But the rate does not enter negative regions.

How does volatility affect returns?

Let us take a look at what volatility does to your investment returns by selecting a different time frame for the investment of Rs.10 lakhs. Let us take the period 1995 to 2006. By doing so we have kept out the biggest fall of the SENSEX in 2008 (-52.45%). Had we taken that the rate of return on the SENSEX would fallen even more than our calculation shows. Read Table 2.

 

Table 2: Investment made on SENSEX Index for Retirement – The Hare / Rabbit
Year	SENSEX (Close)	% change from previous Year	Fund Value at end of Year	Withdrawal end of year 5 % of Fund Val	PV of Bal Fund year end	PV of Withdrawals	Total PV
1995	3,110.49	-20.79%	10,00,000.00	50,000.00	9,07,276.36	45,363.82	9,52,640.17
1996	3,085.20	-0.81%	7,42,100.00	37,105.00	6,24,840.00	31,242.00	6,56,082.00
1997	3,658.98	18.60%	6,98,961.32	34,948.07	5,66,580.00	28,329.00	5,94,909.00
1998	3,055.41	-16.50%	7,94,004.83	39,700.24	4,84,058.53	24,202.93	5,08,261.46
1999	5,005.82	63.83%	6,23,328.88	31,166.44	4,92,132.66	24,606.63	5,16,739.30
2000	3,972.12	-20.65%	9,90,062.19	49,503.11	7,81,558.30	39,077.91	8,20,636.21
2001	3,262.33	-17.87%	7,36,111.60	36,805.58	5,68,121.13	28,406.06	5,96,527.19
2002	3,377.28	3.52%	5,67,768.04	28,388.40	4,05,101.06	20,255.05	4,25,356.11
2003	5,838.96	72.89%	5,59,385.26	27,969.26	3,99,538.19	19,976.91	4,19,515.10
2004	6,602.69	13.08%	9,39,148.70	46,957.43	6,48,658.62	32,432.93	6,81,091.55
2005	9,397.93	42.33%	10,15,030.95	50,751.55	6,42,159.02	32,107.95	6,74,266.97
2006	13,786.91	46.70%	13,93,991.40	69,699.57	7,09,454.73	35,472.74	7,44,927.47
Sources: SENSEX historical rates taken from Bombay Stock Exchange. Funds discounted at the average inflation rate for the year as reflected in the Consumer Price Index on the Website of the Ministry of Statistics and Programme Implementation

To discount the fund flow in Table 2, we have taken the changes in CPI from year to year, as published by the Government. The average inflation rates taken for the period 1995 to 2006, which were used as the discounting rates is given in Table 3 below. We have compared returns to inflation to answer the question: Does inflation erode values of low risk investments while higher risk investments do not?

 

Table 3: CPI Inflation Rate
1995	10.22%
1996	8.98%
1997	7.25%
1998	13.17%
1999	4.84%
2000	4.02%
2001	3.77%
2002	4.31%
2003	3.81%
2004	3.77%
2005	4.25%
2006	5.79%

Going back to Table 2, there were 5 years in which the returns were negative and there were 2 years of very high returns: 63.83 % in 1999 and 72.89 in 2003. At the end of 11 years Rs. 10 lakhs invested in 1995 rose to Rs.13.94 lakhs. In these years the retiree was withdrawing 5 % of the fund value at the end of each year for his or her living expenses.

Assuming the investor liquidates his or her investment at the end of 2006, the present value of all money received from the investment in SENSEX is Rs. 361,473.93 (for the annual withdrawals made) and Rs. 709,928.66 for balance of fund at the end of 2006. Put together the total is Rs. 10,70,928.66. This calculation implies that the investor got a return higher than the rate of inflation. The investor invested Rs. 10 lakhs and got in return Rs. 10.71 lakhs. The investor’s Net Present Value is positive and therefore inflation has not eroded the value of investment.

Now let us take a look at Table 4. In Table 4 we have assumed that the investor keeps Rs. 10 lakhs in a fixed deposit in a bank, renewing it every year. Taking the prevailing interest rates at that time we have calculated the investor’s returns keeping all other conditions of Table 2 intact.

 

Table 4: Investment Made in Bank Fixed Deposit for Retirement – The Tortoise
Year	Average Bank FD Rate	Fund Value at the beginning of year	Withdrawals @ 5 % of the Fund Value	PV of Fund Value at year end	PV of Withdrawals	Total PV
1995	13.00%	10,00,000.00	50,000.00	9,77,590.27	45,363.82	10,22,954.09
1996	12.75%	10,77,500.00	53,875.00	9,27,656.07	45,362.15	9,73,018.22
1997	7.25%	11,01,743.75	55,087.19	9,66,040.92	44,653.83	10,10,694.75
1998	13.17%	11,91,756.21	59,587.81	7,25,381.93	36,327.22	7,61,709.15
1999	4.84%	11,89,849.40	59,492.47	9,30,207.55	46,970.69	9,77,178.24
2000	4.02%	11,78,188.88	58,909.44	9,18,626.30	46,503.31	9,65,129.61
2001	3.77%	11,63,697.16	58,184.86	8,91,928.90	44,906.30	9,36,835.20
2002	4.31%	11,55,667.65	57,783.38	8,14,753.61	41,228.30	8,55,981.90
2003	3.81%	11,41,915.20	57,095.76	8,05,575.39	40,780.37	8,46,355.76
2004	3.77%	11,27,869.64	56,393.48	7,73,163.35	38,950.29	8,12,113.64
2005	4.25%	11,19,410.62	55,970.53	7,13,789.52	35,409.74	7,49,199.26
2006	5.79%	11,28,253.97	56,412.70		28,710.55
					4,95,166.56	12,08,956.08
Sources: The bank fixed deposit rate of interest has been taken from the website of Reserve Bank of India, where more than one rate prevailed in any given year, the average of the rates for that year has been calculated. Funds have been discounted at the average inflation rate for the year as reflected in the changes in Consumer Price Index available on the Website of the Ministry of Statistics and Program Implementation
This Table shows the Present Value of money as on 1995 for the fund at the end of each subsequent year

From Table 4 we can see that had the investor kept his or her money even in a one year term deposit and renewed the deposit at the prevailing rate of interest for the year, the present value of his or her investments would have been Rs. 495,166.56 for the annual withdrawals and Rs. 713,789.52 for the remaining fund in the bank. The total present value is Rs. 12,08,956.08. Again we find that the present value of the returns (Rs. 12.09 lakhs) is more than the original investment of Rs. 10 lakhs. Again the Net Present Value is positive and lo and behold inflation has not eroded the value of low risk investment also!

But here comes the real surprise

The surprise for most would be (that is for those who have had an overdose of the prescription that mutual fund give higher returns all the time for all the people) is that the Net Present Value of Rs. 2,08,956.08 (Fixed Deposit) is much higher that the Net Present Value of Rs. 70,928.66 (SENSEX). In reality, the lower risk bank deposit is much better for investment in the long run than mutual funds.

Low Risk Investments can also be better that high risk investments and also beat inflation by a handsome margin

 

Table 5: Comparison of the Net Present Values
Investment	High Risk (SENSEX)	Low risk (Bank Deposit)
Net Present Value	Rs. 0.71 lakhs	Rs.2.09 lakhs

Net Present Value (NPV) is the Present Value of all cash inflows minus the Present Value of all cash outflow. NPV tells us how much we have earned over and above the money invested in terms of the value of the money invested. For proper comparison in the example we discounted values to the year 1995 and compared the present value of withdrawals plus 2006 fund value to the investment made at the beginning of 1995.

Annuities

If the investment of Rs.10 lakhs had been in a fixed income annuity the Net Present Value would have been even better. There is no volatility in fixed income annuities. Month after month you get the same amount irrespective of the market conditions during the period. More on this when I get the Annuity data of the period 1995 to 1996.

Help India Insure

Study this article, get in touch with me if you want any clarifications or explanations. Though we have not discussed Endowment plans of that period or the annuities of that period (1995 to 2006), we shall do so as soon I get authentic data of that period. Given the pension annuities of Jeevan Suraksha and Jeevan Dhara, I am sure they will be better than banks of that time.

Next time you are discussing retirement plans, remember Life insurance is the only viable option. Help India Insure!

 

 

 

 

So why did the SENSEX give lower returns?

Two reasons

 

The first reason is the volatility of the price movements and our resulting inability to predict the future price with any degree of comfort. In fact the best of investors are right only 50 % of the time they invest. Most are wrong most of the time they take decisions.

 

The second reason is what is commonly referred to as sequence of returns. If you have negative yearly returns early in the period of investment, it will eat up your capital and it takes a long time to again come to some semblance of good fund value. The sequence in which the returns are earned in a given period is very important.

 

A corollary to the sequence of returns is that the more we withdraw from the fund; the lower the returns will be. Post retirement we depend entirely on the retirement corpus created. We must therefore make more than adequate provisions for all kinds of unexpected demands on our money.

 

In our calculations above we had assumed that the investor will withdraw 5 % of the fund value at the end of each year for living expenses. Had we taken a higher rate of withdrawal, the Net Present Values would correspondingly go down. Low risk investments with a constant rate of return are more useful when unexpected requirements crop up in old age. This can be seen in Table 5 where the buffer of a positive Net Present Value is much better in the bank investment as compared to the SENSEX investment. Many advisors advice that the annual withdrawals should not be more than 3 to 4 %, per annum, of the fund value, though there is no particular basis for saying so. The point about retirement planning is to make an estimate of how long one will live, the likely medical expenses, social and family demands while in retirement and so on – all of which are very difficult predict and plan for.

 

Lessons:

1. In the long run low risk investments always give better returns than high risk investments. The tortoise will win and not the hare
2. Volatility of the share prices or mutual fund NAVs produce a risk
3. A steady income even if it is as low as 4 %, p.a., creates better value than a volatile income ranging between -52% to 80 %
4. Low risk investments in the long run are a better hedge against inflation than high risk investments
5. Low risk investments allow greater flexibility to withdraw from the fund a larger amount in any given year for emergencies
6. Fixed and guaranteed income retirement planning (such as annuities) are economically better than variable income retirement planning such as mutual funds
7. It is a fallacy to think that all investors in high risk investments will earn a high rate or earnings
8. It is equally a fallacy to think that “I am the lucky investor who will always get the future prediction right and get high returns”

 

P.S. When you are old and infirm and are unable to maintain demat accounts, passwords, etc., low risk investments offer easier access to monthly income without tensions. After you your spouse may not have the familiarity to handle hi-tech investment platforms to claim the money. A simple annuity going into a bank account is also the most convenient, not just economically better. It is guaranteed to reach you (and your spouse) month after month.