Irrational Pessimism

At the end of the year, I generally write about how the returns of the various categories of mutual funds and other investments have been during the year. However, this year I’m not so sure whether anyone would have all that much enthusiasm for such an exercise for 2011. It’s been a most forgettable year and everyone who has any kind of market-linked investment knows very well what they have lost and would like to put that behind them as soon as possible. My putting some percentages to the pain will probably be neither interesting nor useful.

Unfortunately, most people seem to see as many problems looking forward as they do when they look back. It’s hard to recall a time when the general mood among investors and businessmen was of such pessimism. So much so that one has to wonder how much of this actually makes sense on any rational basis. Remember the phrase ‘irrational exuberance’ that was used to describe the heady days of 2003-2007? Now, it might just be the opposite. We could well be in an ‘irrational pessimism’ or an ‘irrational melancholy’ phase. We could be in a negative bubble (if you could visualize such a thing) and which is as hard to see from inside as the normal sort of bubbles are.

It’s not hard to trot out a litany of economic catastrophes that could hit us. However, the mental weightage that we assign to them could be excessive. The problem is that some of these catastrophes could be self-fulfilling prophecies. If a whole lot of businesses don’t invest in their future, well then the investments won’t be justified. And that’s the same for the investment markets. The irrational exuberance was not justifiable, but I think some rational exuberance may be in order.

(Courtesy: - www.valueresearchonline.com)

Yahi hai right way--to create wealth

All that an investor needs is to be able to differentiate a bad investment from good one—in order to create wealth successfully. However, over the last 4 years, it has become clear that managing one’s reaction to panic situations is as important if not more. It matters how you see and stay through the crisis. 

Data from Mutual Fund registrars suggests a manifold jump in investors investing through SIP. However, it is times like the present ones that have a potential to break this style of investing.  Investors (Informed or otherwise) either cancel or pause their SIPs (and/or lump sum investment) whenever stock markets have crashed sharply over a short period of time. The general message that we get during our regular interaction with investors is “My sip (or lump sum investment) has just completed a year and it’s running in a loss. Markets are looking bad, so I will renew my sip or invest further –as the case may be—once the situation—domestic or global—improve!”

We try to impress upon our clients that it’s the worst thing to do—if not disastrous! The whole idea of SIP is to invest regularly through highs and lows of the market. More often than not we witness the case of another investor who started investing when markets started improving –having stopped at a high level (high defined by hindsight only)! They believe they have done a smart thing…but have they really?

We have a case study (though hypothetical) to prove our point.

Consider an investor who invests regularly in fund that tracks sensex. The investor invests Rs. 10,000/- per month regularly since 1997. In the 15 odd years, he would have invested close to Rs. 17.50 lacs. The investment would be worth approximately Rs. 48 lacs—a return of 13% CAGR.

Contrast this with an investor who pauses every time the market crashes. This investor—typically one amongst us—would be congratulating himself on stopping his investments sometimes in the year 2000 when the market dropped to sub-4000 levels from a peak of 5900. He would have probably started investing when the market approached the 4000 levels again. He would have stopped investing again when the market crashed to 15000 levels from a high of 21000 sometimes in 2008 mid. He would have in all likelihood started investing again in the middle of 2009 post general elections—when the market went up spectacularly.

  

This strategy—which seems to be the most natural thing to do—would have lowered his returns. Instead of earning a profit of Rs. 30 lacs on an investment of Rs.17.50 lacs, he would have earned Rs. 16.50 lacs on an investment of about Rs. 12.30 lacs.

Moral of the story: - We do not know how long the market will remain listless…however, what we do know is that the only sensible thing to do is to continue with your investments. Or as Lord Krishna would have preached: - karma karte raho….Since, SIP ensures that you also buy when markets are down, you should be glad that the market is giving you an opportunity to buy low. Seems to be some kind of a cruel joke, but then is it not the truth….

PPF rate increase to 8.6%--should you be worried?

Till now, it was easy to project and build a corpus using the fixed rate offered by PPF—the best instrument till 30/11/2011 offering tax free 8% p.a.

Traditionally the future projections for PPF corpus, a product with 15 year maturity period, revolved around an approximate annual compounding return of 8 per cent. Most people use their provident fund for purposes such as children’s marriage, higher education, or buying a house. 

Not any more!!

Effective 01/12/2011, Government of India made the following changes with regard to small savings which will impact those who prefer fixed return instruments --in particular PPF investors:-

• PPF rates increased to 8.60%
• Investment limit raised to Rs. 1 lac from present Rs. 70000
• Interest on loan from PPF balance raised to 2% from 1%.
• Commission on PPF deposits abolished.
• Maturity period of NSC and MIS reduced to 5 years.
• Maturity bonus of 5% on MIS scrapped.
• Kisan Vikas Patra (KVP)—a preferred instrument for money launderers—scrapped.
• THE ERA OF FIXED RATE IS GONE! Yes, you read it correctly. The Government has made returns from PPF market linked. Interest on PPF would now be linked to the G-Sec of similar maturity with a positive mark up of 0.25%.

The applicable annual interest rates will be notified by the government before 1^st. April every year.

How will this affect the aam aadmi?

The government’s move implies that it wants the investor to bear the burden of risk of interest rates movement while enjoying the tax breaks.

Being market linked, the rate of return would come down whenever there is a downward revision of interest rates, making it difficult for a person to work towards a long term financial goal, like building retirement corpus, through instruments like PPF.

The strongest message of this move is: - the era of fixed rate of return has in India ended and supremacy of market forces enforced.