The Destruction of Savings and the Threat of Old Age Poverty

The Destruction of Savings and the Threat of Old Age Poverty

By not investing in equities for the long term, too many Indians are setting themselves up for old age poverty

From an investment perspective, India is a fixed income country. An overwhelming proportion of financial savings and investments that Indians make are in fixed income avenues. These are dominated by bank deposits and various government small savings schemes like PPF and National Savings Certificates (NSC). Even the money that we invest in mutual funds is overwhelmingly (70 per cent of it) in fixed income funds.

Interestingly, our love for fixed and predictable returns has somewhat lessened in recent decades. Till about thirty years ago, the very idea of investing in anything else was literally unknown to people outside a limited set who were involved first hand with the stock markets. In fact, the only time some more investors dabbled into equities was when they filled out an application form for an IPO, or just 'issue', as it was then called. This changed to some extent from about the mid-1990s onwards. There arose a small but distinct equity culture where individuals started investing in equity mutual funds in reasonable numbers. Unfortunately, this nascent equity culture is now in full retreat. In the last few years, the number of investors in equity funds as well as the inflows into such funds has been weakening. Last year's (2012-13) data from industry body Association of Mutual Funds in India (AMFI) shows that even among richer investors (HNIs, in the jargon), fixed-income is the preferred asset class.

People who are pulling out of equity--and those who are advising them--try to find some justification for these numbers. Sure, equity returns have been below expectations for some time now. Three-year returns of an average large-cap equity fund stand at 5.4 per cent while five-year returns are also about the same. Meanwhile, fixed-income funds yield in the region of 8 to 10 per cent, depending on the type and the time horizon. However, this is a short-sighted view which inevitably leads to the returns-chasing behaviour. When equity will start going up sharply, then investors will rush in.

However, this kind of self-destructive investor behaviour arises out of not appreciating the fundamental difference between equity and fixed income.

Fundamentally Different

 

Equity and fixed income are not merely two sides of the same coin. They play fundamentally different roles in the economy and in businesses and this difference means that in the long run equity is far superior. This superiority is not incidental to some particular economic situation or to some businesses. It is an inherent characteristic.

Let's examine the differences from the basics. What is the best way of earning money? If you look around, you will realise that for anyone who is good at running an enterprise, the best place to invest is in your own business. However, not all of us can be businessmen. Fortunately, because of the existence of the equity markets, any one of us can become an owner (or rather, a part-owner) of a business. The stock market is basically a way for all of us to reap the financial advantages of being a business-owner with very few of the challenges that a real owner or manager of a business must face. This is the way to get real growth of your money: growth that can beat long-term inflation, and equity is the only option.

To understand why this is so, one should understand what is the source of equity profits. The ultimate source of profits in equity is the growth of the economy. On the whole, stocks grow at a rate that is at least equivalent to the growth of the economy. And the inflation rate is built into the growth of the economy. If inflation is 5 per cent and the real economy grows at 5 per cent, then stocks on the whole will at least match 10 per cent. And that's the average. On top of that, as an investor, if you are able to select stocks that are better than average (through a good equity mutual fund, for example), then you can beat the general rate of economic growth by a larger margin.

If you look at the past trend, then this characteristic is evident. Over a long period, you can expect stocks as a whole to grow about as much as nominal GDP does. The GDP figure that you read about is adjusted for inflation, that is, the GDP is measured and then reduced by the inflation amount. This makes the GDP comparable across years. However, the rupee value of the GDP has increased by the non-adjusted amount, which is called nominal GDP. This is the actual value by which business and other economic activity increases.

If you compare the average GDP for five years ending 2000 with the average of the latest five years with the Sensex, then the GDP is up 5 times and the Sensex is up 4.6 times, which is good enough for most. There may be some caveats to this--like the Sensex is not all stocks but it's a rule of thumb and is an excellent rough guide to the long term growth potential of equities. Of course, this relationship doesn't actually hold if one goes back past 1993--but India was a very different kind of economy at the time and economic growth was not well-connected to business growth. Therefore, what this relationship shows is that broadly, equities will deliver to you what the economy grows by, plus what the businesses grow by.

Fixed income is a different kettle of fish. Fundamentally, fixed-income investing means lending money to someone. When we say lending, it actually includes activities that you may not normally think of as lending. Lending just means giving someone money and getting interest income in return. For example, depositing money and getting interest on it is lending. When you make a deposit in a bank (it could be a fixed deposit or a savings account), you are lending money to the bank. When you make a post office deposit or PPF deposit, you are lending to the Government of India.

However, the scope of gains is sharply limited compared to investing in shares. When you lend to a business (by making a bank deposit, for example), your gains are limited to the interest rate that the business has agreed to pay you. No matter how successful that business may become, you are not going to get more than that. Of course, the risks are limited too. In most such lending, the risk of losing money or not getting your interest is rather limited. The rewards are predictable and so are the risks. Fixed income mutual funds do deliver a twist on this lending theme by trading in bonds, but for the purpose of this article, they principally amount to lending.

We now have the basic principles on which our argument is based. Equity has the potential to deliver growth which is over and above what the inflation rate is, while fixed income (or debt or bond) investments can deliver only same rate of return that is inextricably connected to the inflation rate. Let's take a step back to understand why inflation is such an important factor. Inflation is the effectively the reverse of compound interest, it's like decompounded interest.

Each year's inflation occurs on top of the previous year's inflation, it means that the effect is just like that of compound interest. Consider a situation where you invest Rs 1 lakh in a deposit which earns you 8 per cent a year. At the same time, the prices are also generally rising at the rate of 8 per cent a year. In such a situation, your compounding returns will just about keep pace with inflation.

The actual amount will increase, but what you can do with it won't. So, for example, over ten years your Rs 1 lakh will become Rs 2.16 lakh. However, at the same time, on an average the things you could buy for Rs 1 lakh will also cost Rs 2.16 lakh. In effect, you have not become any richer. The purchasing power of your Rs 1 lakh is still Rs 1 lakh.

But inflation may not be so kind as to stay at the level of the interest you are earning. What if it's more? And what if this goes on for a very long time. Suppose your returns are 8 per cent but inflation stays at 10 per cent and twenty years go by? Your investment would grow to Rs 4.66 lakh but things that used to cost Rs 1 lakh would now cost Rs 6.72 lakh. Now, the purchasing power of your Rs 1 lakh is just Rs 69,000. Your investment has actually made you poorer! This is not a theoretical problem, it's happening all the time to crores of Indians. Our propensity for using bank deposits and other fixed-return investments is the cause of this problem. The problem is especially severe for retired people who depend on long-term deposits for income.

So coming back to where we began--why is India a fixed income country? Despite being a relatively high inflation economy, why don't investors switch to equity more enthusiastically than they have done so? The first reason is that this is actually a circular problem. Because inflation is high, fixed income returns are also high. We can get 8, 10 or even 12 per cent from different kinds of deposits. In earlier times, one could even get 14 or 15 per cent from a bank FD. These returns are low in real terms but the headline number is big. It creates an illusion, a false impression, that you are earning a lot of money. In reality, getting 10 per cent when inflation is 9 per cent is no different from getting 5 per cent while inflation is 4 per cent. Thus, paradoxically, higher inflation makes fixed income look more palatable.

Source : www.valueresearchonline.com