“Do not save what is left after spending, but spend what is
left after saving.” - Warren Buffet
As is common knowledge, there are many ways to save and
invest your funds and generate wealth. After hearing a lot of stories, reading
a lot of testimonials and seeing my friend’s experiences, I am on the Mutual
Funds bandwagon right now. From my experience, investing in Stocks on a regular
basis demands a lot more time, dedication, research and market knowledge than
what I can afford. Real Estate is not really my forte and I am doubtful if the
returns are going to be as exciting as they used to be. If you are a salaried
individual and is looking for a steady investment plan for future wealth
generation, a systematic investment plan in Mutual Funds is a good bet. As they
say, the earlier you start, the better.
Rupee cost averaging
(RCA) is one of the main reasons why I am inclined towards a systematic
investment plan (SIP) in Mutual Funds (as against Stocks). In simple terms,
because you are investing the same amount every month, you end up getting less
units when the price is higher and more units when the price is lower. On an
average, this will help you average out the costs over the entire period. This
takes away one of the major risks of directly investing in Stocks, which is
timing the market. If you don’t follow a SIP approach, you will have to make
sure you are buying when the prices are low. How do you ensure you do that
month after month? Considering a long term investment approach, rupee cost
averaging can even out any market ups and downs in the long term, allowing the
investor to gain maximum benefits on his or her investments over time.
Power of compounding
is the next important aspect to be considered. We often don’t understand the
full impact of this. Consider you are able to invest 10,000/- every month in a
plan which gives you 8% interest (standard for fixed deposit bank plans these
days). Let us say tax is deducted on the accumulated interest every year at the
rate of 30%. If you can sustain this investment plan for 10 years, you will end
up having around 16 lakhs. You will have around 44 lakhs by the 20th
year and 93 lakhs by the 30th year. Let us say you manage to find a
fund which gives you 15% return, in which case you will get around 21 lakhs in
10 years, 80 lakhs by the 20th year and 2.3 crore by the 30th
year. If you can invest 50,000 rupees per month at an interest rate of 15%, you
will have around 12 crores in 30 years. This kind of multiplication is the
power of compounding. Two factors are important here – being steady and
systematic and finding a plan which can offer good returns. Traditional bank
fixed deposits give you a return of around 8% these days. A good Mutual Fund can
give you returns anywhere above 12%, and there are many which can afford 15% or
more. You will be generating a lot more wealth for yourself by shifting your
investment plan from a classic fixed deposit to a Mutual Funds plan.
Can’t you do all these through Stocks? Yes, you can. But you
need to be spending a considerable time each month finding out the best Stocks
to invest in the given month. You have to make sure your picks are diversified
and risk-free. If you are ready to find a list of good performing Stocks, read
up about the companies and keep adjusting your investments by moving it off of
a poor performing stock to a better performing stock at periodic intervals, you
should be able to beat the 12% year-on-year returns that a typical Mutual Fund
offers. But trust me, that is an expert undertaking and will need considerable
knowledge and effort from your part. Investing in Mutual Funds is more passive
and much more secure for somebody who has another full time job to manage.
Type of Mutual Funds
Once you decide on Mutual Funds, your journey doesn’t end
there. You have to decide on the type of Mutual Fund you want to invest in and
then narrow down on a specific Mutual Fund within that type. My pick right now
is to concentrate on Index funds. Look at this article for an experimental
reason - https://www.forbes.com/sites/elizabethharris/2017/02/28/warren-buffet-is-winning-a-million-dollar-bet-with-this-investing-trick-and-you-can-use-it-too/#fdc3d4528b1a
J. In 2007, Buffett took
the challenge that an S&P 500 index fund would best a carefully chosen investment
in hedge funds over 10 years. Smart call. As The Wall Street Journal calculated
last week, Buffett’s chosen Vanguard’s S&P 500 fund (Admiral shares) is
way, way ahead with just under 10 months to go.
Some Jargon and some concepts
It is important that you have an investment story and a
plan. You should do your own research and find out basics about some funds,
observe their performance, invest trial amounts, track progress and adjust your
investments accordingly. To understand more about Mutual Funds, the following
terms may come handy.
·
Benchmark -
A group of securities, usually a market index, whose performance is used as a
standard or benchmark to measure investment performance of Mutual Funds, among
other investments. Some typical benchmarks include the Nifty, Sensex, BSE200,
BSE500, 10-Year Gsec.
·
NAV - The
NAV or the net asset value is the total asset value per unit of the Mutual Fund
after deducting all related and permissible expenses. The NAV is calculated at
the end of every business day. NAV of a mutual fund is the market value of the
assets of the scheme minus its liabilities. It is calculated by dividing the
value of net assets by the outstanding number of units. In simple words, NAV is
the value of each unit of a particular mutual fund scheme on any given business
day. It varies day to day as the market value of securities changes every day.
NAV helps in determining the price at which an investor can purchase or sell
mutual fund units.
·
AUM - AUM
or assets under management refers to the recent/updated cumulative market value
of investments managed by a Mutual Fund or any investment firm.
·
SIP - SIP
or systematic investment plan works on the principle of making periodic
investments of a fixed sum. It works similar to a recurring bank deposit. For
instance, an investor may opt for an SIP that invests Rs 500 every 15th of the
month in an equity fund for a period of three years.
·
Alpha - The
simplest definition of an alpha would be the excess return of a fund compared
to its benchmark index. If a fund has an alpha of 10%, it means it has
outperformed its benchmark by 10% during a specified period.
·
Beta - It
measures a fund's volatility compared to that of a benchmark. It tells you how
much a fund's performance would swing compared to a benchmark. A fund with a
beta of 1 means, it will move as much as the benchmark. If a fund has a beta of
1.5, it means that for every 10% upside or downside, the fund's NAV would be
15% in the respective direction.
·
Standard deviation (SD) - Standard deviation is a statistical measure
of the range of an investment's performance. When a Mutual Fund has a high
standard deviation, its means its range of performance is wide, implying
greater volatility. Standard deviation measures the volatility of the returns
from a Mutual Fund scheme over a particular period. It tells you how much the
fund's return can deviate from the historical mean return of the scheme. If a fund
has a 12% average rate of return and a standard deviation of 4%, its return
will range from 8-16%.
·
Sharpe Ratio
- This measures how well the fund has performed vis-Ã vis the risk taken by it.
It is the excess return over risk-free return (usually return from treasury
bills or government securities) divided by the standard deviation. The higher
the Sharpe Ratio, the better the fund has performed in proportion to the risk
taken by it. Tells how volatile the returns of the fund have been over a
period.
·
Entry Load - A
Mutual Fund may have a sales charge or load at the time of entry and/or exit to
compensate the distributor/agent. Entry load is charged at the time an investor
purchases the units of a Mutual Fund. The entry load is added to the prevailing
NAV at the time of investment. For instance, if the NAV is Rs. 100 and the
entry load is 1%, the investor will enter the fund at Rs 101.
·
Exit Load - Exit
load is charged at the time an investor redeems the units of a Mutual Fund. The
entry load is added to the prevailing NAV at the time of redemption. For
instance, if the NAV is Rs 100 and the exit load is 1%, the investor will
redeem the fund at Rs 101.
·
Yield to Maturity - The Yield to Maturity or the YTM is the rate
of return anticipated on a bond if held until maturity. YTM is expressed as an
annual rate. The YTM factors in the bond's current market price, par value,
coupon interest rate and time to maturity.
·
Compounded Annualised Growth Rate (CAGR) - It is the return of a fund from one point to
the other after factoring in the time for holding investments. It gives an idea
about the value of investment during its tenure. While investments usually do
not grow at a constant rate, the compound annual return smoothens out returns
by assuming constant growth. For example, an investment of Rs 5,000 over a
five-year period has grown to Rs 6,500 and given absolute returns of 30%, which
is very high, but the gains are over five years and, hence, the CAGR is 5.38%
obtained in the following manner - ((6500/5000)^(1/5))-1. CAGR calculates the
growth rate of investment per annum by considering the compounding effect.
·
NPV - Net Present Value - The cash that we
have today is more valuable than the cash that we will receive after five years
due to inflation. Hence, when you decide to invest money each year, you need to
first check how much that money is worth today. This is called net present value
of money.Assume IRR is around 8% for project ‘A’. IRR is also called discount
rate. To calculate NPV of this project, discount each cash flow with IRR
keeping in mind the time lapse. The formula to compute NPV is cash flow /
discount rate + 1^N. The term ‘N’ stands for the number of years
·
IRR (Internal rate of return) - usually used to calculate the profitability of
investments made in a financial product or projects. Internal rate of return or
IRR is that rate of return at which NPV from the above investment & cash
flows will become zero. IRR is the rate of interest that makes the sum of all
cash flows zero, and is useful to compare one investment to another. Therefore,
IRR is defined as the discount rate at which the NPV of a project becomes zero.
Higher the IRR, the more profitable it is to invest in a financial scheme or
project.
·
XIRR is a
more powerful function in Excel for calculating annualized yield for a schedule
of cash flows occurring at irregular periods.
How to select the right Mutual Fund?
Within a category the right scheme can be selected based on criteria
such as past performance of the scheme, comparison with peer set and benchmark,
volatility measures and risk adjusted performance of the scheme, scheme size, expense
ratio of the scheme etc.
Growth Vs Dividend
This is a choice which can confuse a novice investor.
Dividend option means just that – whenever you Mutual Fund announces profit; it
offers a dividend to the investor. The dividend won’t be invested back into the
fund. Growth option does just that – ie, the interim profits which are made are
invested back to the fund so that the overall wealth grows. So if you are
accumulating wealth for future, Growth should be your choice.
Be concerned about
expenses
If you start with high costs, whether you’re paying extra
for a sales fee, a commission, or in pricey expense ratios, you’re setting the
bar higher at the beginning of each year for the investment to outperform the
market. What’s the likelihood that will happen every year?
One of the ways of avoiding higher fees is to go for
‘Direct’ plans instead of ‘Regular’ plans. In case of Regular plans, a broker
is involved as an intermediary, and he/she often gets a hidden fee of around a
1% of your investments. When this is compounded over the life of your
investment, this accounts to a huge sum. Always avoid the middlemen. Do not
invest in third party mutual funds from within your Demat account’s dashboard
just for the convenience it offers. Your Demat account provider will act as an
agent with the Mutual Funds provider and extract a commission from you. Always
deal directly with the Mutual Fund.
Annual reviews
So how can you push your portfolio in the right direction
and what’s the best way to screen your portfolio for excessively high fees?
Consider an investment detox to rid your portfolio of excessive fees. Commit to
a regular review, much like an annual checkup and compare your funds to their
peers — the easiest way is to type each fund’s ticker into fund tracker
Morningstar’s website and look for the category average. Or if you’re working
with advisors, ask them to run the numbers.
Three steps for
trimming costs:
•Schedule an annual review of investment costs; if you’re a
do-it-yourselfer, compare each fund’s expense ratio against its category
average on Morningstar.com. Type your fund ticker in the quote box, click on
the expense tab to compare the expense relative to the category average. As an
example, check out that Vanguard S&P 500 fund and you can see at a glance
its 0.16 % expense ratio has been nearly a full percentage point below the
category average over the last few years. And if you’re working with advisors,
ask them for a breakdown showing cost comparisons
•Perform the same exercise with your investments in your
401(k)s or IRAs
•If you have an advisor, review your fees there too. There
are ample choices to still get help with investment advice at lower costs,
including fee-only financial planners and robo-advisors. Even Mutual Fund
companies offer guidance
Bottom line
Consider whether the gains you’re getting are worth the
haircut you’re taking. Now extrapolate that over a decade or more. Chances are
you’ll come to the same conclusion Warren Buffett did: That unless you’re
Warren Buffett, the best bet for prospering in the markets is to cut the costs
of investing. Index funds are a reliable way of doing that.
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