Risk and return: Make the right trade-off

An SIP in an equity fund can reduce the average cost of investing and boost return. But it can’t eliminate the risk of loss of principal.

I was talking to a prospective client, Mayank, a 55-year-old self-employed professional, who wanted to invest for retirement. He is a self-proclaimed conservative investor. “I do not want to take undue risks and I intend to invest for 10 years or more,” he said. All good so far. But his next statement floored me. “My return expectation is only 10 per cent.” He made it sound like a very reasonable expectation.

I asked him how he had arrived at this “reasonable” expectation. He reply was vague. But in a nutshell, it was, according to him, a reasonable step down from the 15 per cent return that equity investments reportedly provide. This step down was to account for his conservatism in investment. By conservatism, he meant ensuring that the principal amount would remain intact.

When asked which instrument provides such security, the obvious answer was a good bank’s fixed deposit (FD). He was willing to take a little more risk than that. In return, he wanted his post-tax return to go up to 10 per cent.

I had to bring him down to earth. Today a 10-year FD from the State Bank of India fetches 5.4 per cent per annum. Taking a tax rate of 31.2 per cent, the post-tax return works out to 3.72 per cent per annum. Mayank was expecting a 10 per cent post-tax return (more than 2.5 times the FD return), which he felt was very reasonable. It would have been reasonable if he were willing to take the risk and invest in equity-based instruments. But he was clear he did not want to invest in any instrument where the principal amount could be eroded. And yet he expected a return of 10 per cent per annum. I told him that an instrument that “guaranteed” his principal at all times, and where the return expectation was 10 per cent per annum on an average, did not exist.

At this, Mayank spoke of investing in equity mutual funds through a monthly Systematic Investment Plan (SIP). The advisor who advocated this option had mentioned that he would probably earn double-digit percentage return if he continued to invest in a disciplined manner for 10 years. I mentioned to Mayank that we had studied the data on investing through 10-year monthly SIPs in a Nifty index fund. It showed that there was a good chance that he would make double-digit returns at the end of 10 years. In fact, past performance data seems to indicate virtual certainty of a double-digit return if, at the end of eight years, he started systematically transferring the accumulated corpus into a liquid fund.

But the data also showed it is almost certain that at some point during those 10 years (sometimes as late as the eighth year) he would suffer a loss on the principal amount invested. It would be his ability to continue investing through such times that would most likely result in the double-digit return he so craved.

A monthly SIP in an equity mutual fund is an excellent way to reduce the average cost of investing and boost eventual return. But it is not a magic bullet that removes the risk of seeing a loss of principal. If Mayank persisted in his desire for a capital-guaranteed investment that gave 10 per cent return, it was inevitable he would be cheated by a smooth-talking salesman into investing in an instrument that promised so but did not deliver.

We were able to convince Mayank to make an informed trade-off between improving the chances of getting a double-digit return by accepting the inevitability of seeing loss of principal amount invested during the 10-year tenure.