Play equities while keeping your capital safe

Play equities while keeping your capital safe

 

A look at another combination strategy — of fixed deposits and equity investments — that does not involve taking on too much risk

 

Sandeep Shanbhag

 

"Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little."

— Fred Schwed Jr

The rains don't seem to have doused the stock market fire. After over two-and-a-half years, the Sensex has breached 19000 again. FIIs can't seem to have enough of our markets. And not surprisingly so. A GDP growth rate of 8-8.5% makes India one of the fastest growing economies. A near absence of the toxic assets that the West is reeling under, limited dependency on exports and foreign capital, robust corporate earnings growth on the back of domestic demand, savings rate of 35% and a favourable demographic makes India one of the most attractive investment destinations in the world.

However, there are some dark clouds. Valuations aren't cheap. At 21 times earnings, the market is already one of the most expensive in the world. Also, inflation is rising and consequently so are interest rates. A high interest-rate environment will dilute corporate earnings. This is a major red flag. Moreover, if the West slides back into a recession, liquidity supply, which is essential to maintain this rally, may dry up.

So under such circumstances, what does the retail investor do? On one hand, temptation to ride this boom is tremendous. On the other, the risk is greater than ever before. What then is the way to benefit from this market surge and at the same time limit risks?

Last week, we saw one way to do that. Invest a major part of your capital into a bank fixed deposit such that over five years the money grows back to the original amount you started out with.

Another way is to invest your entire capital in a fixed-income instrument and invest the consequent returns in equity. This way too, your capital is intact, yet you can benefit from an upside in equities.

As we did last week, assume that the capital is `5 lakh. Invest this in any bank deposit. At an interest rate of 8% per annum (pa), you will get `40,000 per year or `10,000 per quarter. Now, this amount is fully taxable. Assuming you are in the 30% tax bracket, the net balance after tax left would be `7,000. Now, invest in a quarterly SIP in a good equity-oriented fund with this amount.

The bank deposit is for five years — so basically, you would invest `7,000 per quarter for five years. At the end of five years, you would receive the market value of your mutual fund investment and also the capital amount of `5 lakh invested in the bank FD.

Consequently, while you have kept your capital intact, you have also taken equity exposure with all its risks. So no matter what happens to the market, your `5 lakh is safe.

To see how this strategy works, we ran some numbers to see how the plan would have worked out had it been implemented five years ago. Say you received your first interest in September 2005. The quarterly interest was invested in Reliance Growth Fund on a quarterly SIP basis. By adopting this simple structure, at the end of five years, the investor would have received around `2.52 lakh just on account of the mutual fund investment!! The effective rate of return works out to an astounding 25.28% p.a. Add to it the capital amount of `5 lakh of the Bank FD and the total investment would net a whopping `7.52 lakh, done and dusted — after tax and without an iota of risk!!

Some points to chew on

Now before you start looking for your cheque book, consider the following.

Firstly, the above analysis, gives us only an idea about what would have happened had this strategy been implemented through the past five years. But who knows the future? Perhaps you would earn less or perhaps you would earn so much that the `7.52 lakh may seem a pittance. But whatever happens, rest assured that your base capital of `5 lakh remains protected.

Which brings us to the second aspect of this exercise — that it is only your base capital — the `5 lakh, which is protected. But it does not cover inflation. Obviously the value of `5 lakh five years later would not be the same as it is today. But hey, with no downside and only upside, it's a deal worth considering, isn't it?

Some readers may point out the analysis will change as per the interest rate assumed. True — one can do the same exercise incorporating the relevant interest rate for each year. But that would just compromise simplicity for accuracy. The point of this article is not the precision of the numbers i.e. not how much exactly your capital would have grown to — but the fact that adopting this strategy allows you to enjoy pure unadulterated equity pleasure with the guarantee of not losing your base capital.

Similarly, the scheme selected (Reliance Growth) is one of the many well-performing equity diversified schemes available. The scheme doesn't matter. You will find similar results from other fund schemes as well.

Last but not the least, we have assumed a quarterly SIP for the sake of simplicity. An investor could very well adopt the same strategy with a monthly SIP — only take care to invest in a bank FD with monthly interest.

So who's afraid of equities now?