NECESSITY OF HAVING EQUITY IN YOUR PORTFOLIO

Amongst all the asset classes, equity is the only asset class that seasoned investors swear by and new investors dread. Equity represents the shareholders’ stake in the company, or the amount of money that the company would return to its shareholders if it liquidated all of the company’s assets and paid off all its debt. Equities are riskier than many other asset classes, and generally produce higher returns in normal times, and lower returns in difficult times. Investors use the direct purchase of equity (shares/stocks) or mutual funds as the two most used means to invest in equity. We discuss below the various reasons that make equity an important constituent of your portfolio.

Beats Inflation

Inflation in the last four decades was at an average of7.89% and investors relying solely on fixed income instruments and its interest income found it difficult to beat it because of the net rate of return post taxation. Historically, equity has beaten inflation 60% times in the 40-year span from 1980 to 2019. The average inflation of this 40-year span was 7.89% and the average equity returns of the same period were 12.29%. In the 24 years that it has beaten inflation out of 40 years, the average margin of difference is almost 37%.

To drive home the point further and considering that the value of SENSEX in 1980 was 100, we presume that our monthly expense at that time was ₹ 100 and at the same time we also invested ₹ 100 in SENSEX to keep our base parameters on even playing field. However, after 40 years with the average annual inflation rate of 7.89%, our monthly expense has increased to₹ 2,086. Simultaneously, the money invested in SENSEX has grown to ₹ 17,059 at an annual CAGR of 13.71%. The chart below relates to this example and unambiguously shows that SENSEX beats the inflation by a handsome margin.

Wealth Creation –

Equity is the best possible asset for wealth creation in the long duration (see chart below) because of its superior returns. Young investors must bear this in mind because they have the age in their favour, which also increases their ability to take more risk. The basic principle of equity investment is to buy low and sell high. However, it is easier said than done because it is well-nigh impossible to time the markets. Therefore, it is prudent to invest systematically and regularly using the systematic equity plan (SEP) route for buying shares and systematic investment plan (SIP) for buying mutual fund units. This averages your investment cost and overcomes the market volatility. In case some investors find it difficult to invest regularly due to irregular income, they must use the systematic transfer plan (STP) to keep their lumpsum money in a liquid fund and then transfer it regularly in small instalments to an equity fund. Simultaneously, all investors must follow the market and top-up their investment in falling markets or dips in the market. This way they will buy more at lower prices and thus accumulate more units/shares.

Better Returns Than Other Asset Classes

In the last 40 years, equity has outperformed all other asset classes with the BSE Sensex giving a compounded annual growth rate (CAGR) of 13.71%, much higher than gold giving 8.48%, silver giving 6.92%, public provident fund (PPF) giving 9.41% and fixed deposits (FD) giving 8.62%. The chart[1] below comparing the last 15-year returns depict that averagely equity has given superior 16.6% returns in the large-cap and 21.2% returns in the mid-cap segment. These are better than debt giving 5.7% and gold giving 11.7% during the same time span.

[1] Source: https://www.icicidirect.com/

Falling Interest Rates

A lot of senior citizens rely on their monthly expenses on the interest/returns income from fixed income instruments. I am aware of one such case where, about five years ago, a retiree had invested his entire retirement emoluments of ₹ 50 lakh in FDs. That time he had invested at 8% interest rate, on which he earned approximately ₹33,200 monthly interest payout. This was adequate for him to meet his monthly expenses of approximately ₹ 30,000 and save about ₹ 3,000 per month. Now when this gentleman wanted to reinvest his FD, after its maturity period of 5 years, he realised that the interest rates for senior citizens currently hover at 6.2%. This means he will only receive₹25,700 as his monthly interest payout. Simultaneously, his monthly expenses have risen to approximately ₹ 40,000 because of 6% annual inflation. This phenomenon of falling interest rates has severely disrupted his monthly income and he is at a loss to even meet his monthly expenses. This necessitates that even senior citizens must invest about 15 to 20% of their total net worth in equity, which gives superior returns of 12 to 15% eventually. Their fears of loss are best allayed by the chart[2] below that shows the probability of loss reducing with time. The chart very clearly indicates that as time increases, volatility decreases and the probability of loss decreases.

[2]Source: https://investingfunda.com/a-beautiful-view-sensex-stock-market-returns-over-the-long-term/

Tax Treatment Benefits –

Unlike the fixed income instruments where the government taxes the entire interest earned in the financial year at the applicable tax slab rate of the individual, equity enjoys a favourable tax treatment. On equity, the government levies only capital gains tax on short-term gains for securities/units held for less than 12 months and on long-term gains for securities/units held for more than 12 months. In real terms, it means that the government taxes both realized and accrued interest on FD in a financial year. Whereas, in the case of equity it taxes only the realized capital gains at the time of selling/redemption of equity. Ipso facto, there is also a tax deferment on equity to the year of selling/redemption. Government levies tax @10% (without indexation benefit and foreign exchange fluctuation) on long-term capital gains exceeding ₹ 1Lakh and @15% on short-term capital gains. Common to both, it also levies a surcharge at the following rates: @37% on base tax where specified income exceeds ₹ 5 crores; @25% where specified income exceeds ₹ 2 crores but does not exceed ₹ 5 crores; @15% where total income exceeds ₹ 1 crore but does not exceed ₹2 crores; and @10% where total income exceeds Rs. 50 lakhs but does not exceed ₹1 crore. Further, it levies a health and education cess @4% on the aggregate of base tax and surcharge.

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Disclaimer: Dear Investor, By clicking on the submit button you will be redirected to our secured website. This link is provided only for the convenience of our visitors. The site has the necessary tools to help you understand your risk profile, asset allocation, and goal calculations. You will also be able to open a folio and transact online in mutual funds.

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