Take Control, Invest Actively : Active Investing Series Part 1

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We start a series today on what we call “Active Investing”. A multipart series on how you think about your money so you can manage it better. There is just too much bullshit on investing for the non-full-time investor, including on this site. You want a simple way to think and do. We’ll explain.

The Investing Process: Think, Plan and Do

You want to save and invest money. Largely because it’s the done thing nowadays. If you don’t have any savings, then stop here; you will just get bored. If you’re saving money, then what are you really doing?

Most people are conned by bankers into some silly insurance plan, others keep buying real estate and some will buy gold. Before going into anything further, these are just “instruments”. You haven’t even started to figure out what you’re doing yet.

Strategy versus Tactics

My ex-boss, let’s call him EH, told me one thing: Strategy matters more than tactics. More work is done thinking about what to do, than to just go do. Tactics is about choosing a fund, about buying the fund, about tracking it. Strategy is about sitting down and building out what you want from your investing life, understanding how you will get there and giving a framework to your eventual tactics.

We want to focus on strategy first. 

What we think you should do is think about where you want to be. You have some idea about where you’re going, but no exactness. You have no idea exactly how things will turn out for you (will you be in India? Will you make a big bonus? Will you have huge hospital bills?). You can however make some assumptions:

  • I’ll stop working at 60. Then, my savings should be enough. I won’t depend on my kids.
  • I want to buy a house.
  • I want to pay for my kids’ education. School and College.
  • I want to pay for their marriage too. Because.
  • I spend Rs. 60,000 per month today.
  • Inflation, for me, is about 6% a year.
  • I need something as emergency funds today in case I lose my job.

All of these can change. Buying a house is all right but not supremely important anymore. Your kids may not want your money at their marriage. You may see higher, or lower inflation. But you make these assumptions today.

The Genesis of a Financial Strategy

Now you start thinking about where you need to be. You’ve already figured out what you need.

  • An Emergency Fund of 6 months expenses = 360K. 6 months is good enough. It will change as your expenses change.
  • A way to save enough money to make you independent after your stop working. (Let’s call this “Retirement“)
  • You want a Children’s Education Fund.
  • You  want a Kids’ Marriage Fund.
  • You want a “Having Fun” corpus. Because we say so. Because this is what money is for. If you can’t get drunk in Italy and run through tomato infested streets in Spain and not worry about money, then you are wasting your life. And we can’t allow that.
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How much do you need for each one? We’ll get there, don’t worry. We’re going to stay a little away from the specifics, because we want to encourage you to answer this yourself.

We have mentioned the concept in a previous post: Saving for retirement: How much is “Enough”?

But No, How Much?

To work out how much you need for retirement, you think of it like this:

  • I spend 60K a month today.
  • I retire 20 years later.
  • With inflation at 6% a year, I will spend Rs. 1.92 lakh a month. This is not crazy. This is to having spend Rs. 19,000 a month in 1996, which is equivalent to your spending 60K a month today.
  • That means I need to get something that brings me a cash flow of 192K a month, about 20 years later? That’s Rs. 23.09 lakh per year.
  • At retirement, I think I can earn about 8%, blended, from my investments. That means if I have 1 cr. I will earn 8 lakh per year. So does this mean I need 3 crores after 20 years? No.
  • After retirement, for year 1, I will spend 23.09 lakh. But then, inflation. So Year 2 after retirement I will spend 24.48 lakh due to 6% inflation and so on.
  • So I need enough of a corpus to keep meeting my “increasing” needs till I reach the age of 90.
  • After some trial and error, I find that the amount I need is about Rs. 5 crores – which will “finish” by the time I’m 90.cash-flow

Want to learn how to use Excel for making these calculations? See our Webinar Video!

As you can see, this is a fairly simple calculation. At age 90, this assumes you’re spending Rs. 1.25 crore per year, or Rs. 10 lakh per month. Which may be impractical, but then our brain doesn’t understand compounding that well. Rs. 10 lakh after 50 years is the same as 60K, or Rs. 0.60 lakh today, at 6% inflation.

So Now, I Know Where To Go

I need to get to Rs. 5 crores in 20 years.

This is the retirement goal. Get to Rs. 5 crores in 20 years.

Let’s just say I have saved Rs. 20 lakh so far, till age 40. This is all I have. How do I get to 5 crores?

It’s not unachievable.

Now, We Get To The “Achievable” Return

We still aren’t talking which mutual fund or which stock. We don’t care right now. Remember, it’s the process. We know where to go. We just need to get to Rs. 5 cr in 20 years. We can get there by anything – stocks, mutual funds, real estate etc.

Then, we look carefully. We have 20 lakh. We need to get to 5 crore.

If you do your standard calculation, then you need 17.5% per year for 20 lakh to become 5 crores in 20 years. Possible?

Sure! In the last twenty years we saw a growth of approximately 10x on the Nifty (12%), and one fund which launched in 1995 – Reliance Growth Fund – has returned 90x in about the same time, which is 25%. (Again, a big win for active investing, but we digress)

But the next twenty years are not going to be the same. The last 10 years weren’t the same. We saw the Nifty only go up about 9.5% per year from 2006 to 2016. That same fund – Reliance Growth – went up about 14.7% per year.

Betting on 17% is fraught with danger – it’s too much risk and a very low chance of a great return.

But at the same time, your “risk free” rate is around 7% today. That’s what you can get in the lowest risk instruments around, especially if you look at the 20 year government bond (2036 maturity).

So 7% is the minimum. 17% is a tad high on risk, perhaps. SO what do you do? You can then choose a number in between, or 12%, for a reasonable return. 

For an investor, getting 12% is a good deal. It’s 5% greater than the risk free return on a 20 year period, and it’s not so high that you can’t achieve it.

Now I Know Where To Go, And How Much Return I Can Expect

I need to go from 20 lakh to 5 crores. I estimate I can get 12% a year. This is a good start.

Now, you work the numbers. 20 lakh alone, in 20 years, will only grow to Rs. 1.92 crores at the 12% return. How do you get the rest?

The answer: You Invest Every Month.

How much? Look, in 20 years, your income will increase. So you can increase the amount you invest. Let’s say you can increase it by 10% every year. Calculating backwards, here’s how you get there: You invest Rs. 15,700 per month in year 1. Then you increase this amount every year; in Year 2 it’s 17,270 per month. In Year 3, around 19,000 per month and so on. Here’s how you get there – with returns of 12% per month on that plus your initial capital of Rs. 20 lakh.

investment-flow

Want to learn how to use Excel for making these calculations? See our Webinar Video!

And This, Dear Reader, Is Your Financial Strategy for Retirement

See, you got there by just some calculations:

  1. You invest 20 lakh today
  2. You attempt to get 12% returns
  3. You will add Rs. 15700 per month
  4. This amount increases by 10% every year
  5. And when you’re 60 (20 years later) you will have Rs. 500 lakh (5 crore).
  6. This money, at 8% a year, will last you till you’re 90, assuming inflation is at 6% and your expenses are the equivalent of 60K today.

That’s it. Finished. Now, you have to get down and do it. Now for the tactics.

In subsequent parts in this series, we will speak of building your own plan in a larger way, thinking of other goals you can properly define, and how to map your progress.

The Tactics: Where To Go and What To Do?

Only after all this do you say: Now what do I buy?

Why does everyone say “Invest in stocks”, or “Buy mutual funds”? Because you apparently get a higher return when you do.

This is pointless. You want 12% a year. That’s about it. You don’t want supersized returns. All they will do is make you take more risk. If you get an 18% return, it’s great, but since you expect 12% in the longer term, you can then slow down; further money can be put only in “safe” instruments, waiting for the market to bring your “average” return down to 12%. Either the market will fall – which allows you to reinvest whatever you didn’t invest, at lower valuations – or you will find that you’re automatically diversifying into part-equity, part-debt.

Let us plant the seed of an idea into your head.

How much “more” have equity markets returned compared to risk free returns?

The “Equity Premium” – Higher Return for the Higher Risk

Liquid funds don’t fall in NAV. (Okay maybe at extremes but they mostly don’t). Equities fall all the time. You may require money when they have fallen. Which is the risk you take.

You expect to get a higher return for that risk. In India there has really been ONE period when that risk has been adequately compensated, and that period was 2004 to 2008 or so. Let’s demonstrate.

We take an “SIP” into a liquid fund (a systematic monthly investment, or a Systematic Investment Plan) which is the safest instrument around. Then we compare that with an SIP into the Nifty index, with dividends reinvested. (We use a “Nifty TRI” index for this purpose, whose data is available since 1999).

Take a 3 year SIP and see the rolling returns over time for each component. Rs. 10,000 bought every month into either investment, shows us the “easy” earning (liquid funds) versus the risk (Nifty). The compounded return differential between the two is the “Equity Risk Premium”.

Now if you can get 6% risk free, you should be able to 12% when you have risk. The difference between “risk free” and “with risk” is the premium the market is giving you for taking this risk. That premium has changed over the years. In India, a 10% risk premium is awesome. Ignore the early years, but over time you can see that the Equity Risk Premium goes up very heavily and then comes back down to nearly equal to the risk-free SIP, and then goes back up.

equity-risk-premium-india

You can see here that even at a three year level we haven’t really lost too much money compared to a liquid fund. We may, of course, see this change in the future.

But it also tells you this: if you’re seeing a risk premium close to 10% or more – at least in the last 7 years or so – you are likely to see the market fall and correct this premium over a short time.

One way you can build your tactics is that you will keep a higher allocation to equity, in general, when the Equity Risk Premium is lower than +10%. Above that, you’re going to not invest further in equity.

This means a tactical plan is like this:

  • I invest in a blend of equity and debt for my retirement.
  • I want about 12% per year
  • I know – from the excel sheet above – how much I need to be at every single month from now.
  • I need to find investments that yield me 12% a year
  • I start with 50% in debt funds – a “Dynamic bond” fund sounds useful when interest rates are falling. I might split this amount into some “Liquid” funds and the rest in bond funds.
  • The other 50% goes to an equity diversified mutual fund, or direct equities or such.
  • Every month I invest Rs. 15,500 in a similar proportion – half debt and half equity.
  • If the Equity Risk Premium crosses 10% I put no money into equity.
  • I check at the end of the month : am I where I’m supposed to be? (See third point above) That involves adding up all the investments and seeing the total current value. If I’m Rs. 3000 short, I will invest Rs. 3,000 more next month.
  • If I’m at where I need to be, or higher, I will not invest – I’ll just put the money into a liquid fund. Then I can use that money when I fall short at a later date.
  • Every year I increase my monthly investment by 10%.
  • In 20 years, I’ve cruised to my goal. I can change the assumptions, I can change the amounts – all it does is gives me new numbers for each month going forward. My tactics are all built to reach my goals.

You can’t be exact – you need to leave lots of buffers. But the main point is this: Investing actively, according to us, is to take control of your future and to target your goals. Without that, you just blindly invest without knowing whether it’s enough, it’s going well, or it’s worth your while.

Your financial strategy is more important than the tactics. Notice how we didn’t say “which fund” or “which stock”. All that is tactical and can change. Even taxes are tactical – your tax arrangement in one year will determine what you invest in – but the strategy remains the same: Get the 12%, Invest X every month, Match yourself to your goals.

More coming up in immediate posts. Tell us what you think.

Read the Other Posts:

  1. Feedback and Q&A on Part 1: Taxes, Allocations and more.
  2. Part 2: Using Covered Calls To Reduce Cost, and Generate Business Income.
  3. Webinar: How To Hedge Your Portfolio

The first part of this series is open for non-premium investors, and some subsequent articles may only be for Premium members. Subscribe now!

Want to learn how to use Excel for making these calculations? See our Webinar Video!

18 COMMENTS

  1. # to add on , another important element of PF makes it further easy for some one working to achieve this . 6-8% average salary growth and approx 6% weighted average PF return for some one at 40 years and working. The PF amount itself may add up to 2.1 Cr for some one at Age 40 , drawing a PF Of 20000 and has a corpus of 10 lakh in PF

    Nicely done. the 5 Cr looks more realistic than some insane retirement calculators going up to some 12-15 Cr .

    Also , as the tech advances , i see cost of living reducing . Power charges may reduce with better delivery of power , power availability will reach to 100% , Food prices may come down given the pilferage in next 20 years may reduce with better transportation and storage facilities.

    • Brilliant – yes, the PF piece is a tactical one and I think a great one to work with.

      You’re right. I didn’t think a retirement income will be as low as it is today, and our calcs may all be screwed up! But you have to use a base, and then reduce it over time

  2. Thank you, this is a really nice perspective. One way to perhaps look at the 12% return required per year, is to break it down into earning ~1% per month, or ~0.25% per week. This seems easily achievable, especially with StratOptions!

    • You should never take taxes into consideration – you might see equities get taxed next year and then removed 10 years later, you have no idea when etc. Plus in both cases you will only see taxes when you exit – and you will alwasy exit in smaller chunks (to take care of expenses) which will be taxed lower. So taxes shouldn’t be considered at all, IMHO.

  3. I think taxes should be considered. You never know. Indian tax laws can change any day. It will not only cause a serious crash in the market (imagine equity/equity oriented MF investment taxed at marginal rate for less than one year period or even for that matter for more than 1 year period, means, taxing the way real estate is taxed presently). Or see last year when Government changed the way Debt fund was taxed.
    The example given is a simpler one taking into account only one goal i.e. retirement corpus and planning, etc.
    Imagine some one is having multiple goals, like, children education, children marriage, joy trips and of course retirement planning and the complexity it brings.
    Any how. I have done it for my self and a number of my well wishers. It is working OK as of now.

    • THe point is this – don’t consider taxes. When you retire, you won’t take money out in one shot, you’ll take it slowly and the money will have lower tax slabs.

      Multiple goals are also not very complex to do, will highlight these.

  4. Excellent. After 10 years of working, I was living pay-to-pay, with 3 loans and no savings (I had even encashed my PF while switching jobs). Then made by financial plan excel till end of life, very similar to what you have shown here. That was eye opener.

    Now after 5 years, I am debt free and saving regularly. Total savings reached only 15 Lakhs, looks miniscule compared to target of 5Cr. But as you have shown, compounding is a friend which we can rely on :-)

  5. I like the initiative at simplicity and demystification – you are targeting something deep inside investor territory. While trying to figure out the key pillars of the proposals, it appears to me that your fundamental premise of 5 Cr. and 12% returns is based on manageable step-up SIPs which is good, but more importantly, the boundary setting ‘ lakshman rekha’ of not crossing 10% equity premium. This also introduces the concept of ‘timing’ the market which none of the investors are comfortble with

    However, I believe there are two key costs not considered, i.e.,
    (a) I will have to continuously track or, pay a reliable advisor to track e.g., capital mind team and (b) manage the cost of switching between Active or Balanced to Liquid funds which is at least 1% for every switch i do when the Equity premium Lakshman rekha is crossed (e.g., 0.5% switch out Equity and 0.5% switch into Liquid)

    So that leads me to think, how many times are looking at making the switch in a 20 year period,… what would be the switch costs that would eat into our target 12% returns… and can we identify some triggers in the next set of articles..

    • You don’t have to switch – you just slow down subsequent investments in equity until that equity premium is lower. You needn’t even use the equity premium to time it – it’s just an additional input if you can do it. It’s like an excel sheet with just one entry a month. If you don’t use it, that’s also fine.

      You don’t want to spend too much time switching. The idea is this: This month, should I put my money half into equity half into debt, or simply invest everything in a liquid fund because stuff looks blown out of proportion? that’s all you need.

  6. Though its well written, I see a flaw here. Most of the private sector jobs are in uncharted territory for people >40 years of age. Its scary to assume that one will work till 60. Therefore one should build a model that assumes you are retiring by 40. Whatever you earn after 40 should be considered a bonus.

  7. Deepak, one of the best written article. This article makes it quite scary to live up to 90. It needs diligent saving for 20 years, hell lot of planning to generate 12% return for next 30 years and to maintain decent health upto 90 (lighter vain).

    This is what I foresee with 99.9% of the earners in India. Mushrooming of three sectors would somehow destroy this planning for every earning individual in the country. Real Estate, NBFCs (gadgets & auto) and Jewelry. Give offer, it is easy to lure anyone. With stock market listing, private equity, international outreach, these listed entities are becoming smarter and smarter and finding all innovative ways to strip money. I could not imagine that 1 Cr loan for 20 years is not a big deal for many.

    I wonder how many people who retired this year did the retirement planning in the age of 30,40 & 50. Except the pension folks from govt service, hardly seen anyone who planned for retirement. Even with NRIs, it is no different. I see somany NRIs who are touching 60 and earned so well in prime years are somehow pushing to continue in jobs as reality hit them that they could not afford a retirement. Sad story but blame it on real estate etc..

    Coming to the article, I feel somehow generating 12% return is not realistic for so many years. I would plan with 8% return. Would accept the fact that not be able to live the same life style post retirement. Take public transport instead of car, won’t go to restaurants to eat, cut down expensive groceries including meat, buy less expensive clothes etc.. Best part is one could afford to lower their life style in India which is not possible in developed world. All is not lost. Way to go

    • Thanks Krish. I think retirement isn’t that difficult. Getting a 12% return may not require quite as much in terms of planning, to be honest. I’ll demonstrate in future posts.

      My thought is to seed the thinking. Plus, we will be going down the “wealth management” route and can help as well!

  8. On the risk premium calculation for investing in equity or not
    1) Why choose a 3 yr rolling SIP and not a 1 yr ?
    2) Are you suggestion check the risk premium value each month and decide on investment into equity or not?
    3) If not in equity the SIP amount should go to debt funds fully for the months where risk premium is below 10%?

    Is this some kind of dynamic pro-active asset-allocation that you are suggesting? Generally all asset-allocation suggestions are reactive but this sounds rather smart. Please help clarify above Qs. Overall a
    wonderfully written article. Thank you very much.

    • 3 year is more smoothed than a 1 year. I would take a 5 year but we don’t have that much data.

      Using the risk premium is optional – but it’s one way to asset-allocate.

      SIP should go into liquids for the high risk premium times. That will then be pummeled back into equities when the risk premium falls.

Comments are closed.