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Fake News On Investment: Absolute Vs Annualized Return

Yesterday, I read about an investment strategy in a leading business newspaper.

The plan was (almost) Ok. But, the troubling part of the article was its rather misleading calculation methodology. It (wrongly) implied 'very high' returns from the said investment.

I am worried that many novice investors, who do not understand the nuances, may make a wrong choice given that its a large and trusted publication.

More so because the strategy is particularly useful for the risk-averse investors. For many people the safety of capital is of paramount importance.

Hence my concern about (a) the calculation that indicates much higher yield than actual and (b) the rather 'risky' nature of the investment strategy suggested.

My analysis is divided into three parts...
... Brief description of the investment strategy
... Yield calculations presented and what's wrong with it
... A slight modification in the plan to reduce the risk

Part A: Investment Strategy
The basic plan of action suggested is pretty simple and straightforward.

Step 1: You put a large sum of money in a fixed income investment which gives monthly returns.
Step 2: Every month you invest the interest received into Equity Mutual Fund SIPs.

In the worst case scenario your capital is safe. While, the interest portion is invested in equity to improve the returns.

As per the strategy published, you have to invest in a NCD (Non Convertible Debenture) issued by an NBFC. It's a 10-year NCD at 10.15% rate of interest payable every month. Thus, if you invest Rs.12.50 lakhs, you will receive around Rs.10,000 per month as interest income. With this Rs.10,000 you do monthly SIPs in equity mutual funds for 10 years.

Assuming 12% p.a. returns from SIPs, you will have accumulated Rs.23 lakhs in equity funds in these 10 years. Plus, you will get back Rs.12.50 lakhs that you had invested in the NCD.

Thus, your investment of Rs.12.50 lakhs would be worth Rs.35.50 lakhs after 10 years.

All this is perfectly fine... except one point, which I will discuss in Part C.

For now, let's focus on Part B — the crux of this article — i.e. the misleading calculations.

absolute-vs-annualized-returns
Whatever may be the source of news, always crosscheck and verify.

Part B: Misleading Yield Figure
As per the published article,
- the Absolute Return from investment is = Rs.35.50 lakhs / Rs.12.50 lakhs = 184.03%
- and Yield of Investment is = 184.03% / 10 years = 18.4%.

This is presenting a WRONG picture. In financial parlance, this is the Absolute YieldIt is 'simple' mathematics that DOES NOT TAKE INTO ACCOUNT the 'compounding factor' over the 10 years of investment horizon.

In reality, it the Annualized Yield that matters.

Whenever we talk of annual return or yield, it is implied that the earnings are compounded every year. That's the very basic assumption. That's how we can make 'meaningful' comparison among different types of investments, delivering varied types of cash flows. If we do not compound the returns on annual basis and bring all investments at par, we cannot know which is the most profitable investment. Given the levels of financial literacy, I have serious doubts whether investors will be able to make this distinction between Absolute and Annualized Returns.

To calculate the TRUE and CORRECT yield of the above investment, you have to simply use the Compound Interest formula you learnt in your school. Alternatively, if you have forgotten, just ask your school-going child. Even s/he will tell you the correct answer.

Amount = Principal * (1 + Interest Rate)^No. of years

Rs.33.50 lakhs = Rs.12.50 lakhs * (1 + Interest Rate)^10

Solve the above equation and you get Interest Rate = 11% p.a.

Yes, 11% p.a. is the actual yield or return from the above investment and not 18.4% p.a. (Note: Your child will get zero marks in exam, if s/he writes 18.4% as the answer.)

Actually, even logically speaking 18.4% is wrong. The debt portion is at 10.15% p.a. rate of interest. The equity portion is assumed to yield 12% p.a. returns. So the combined yield cannot jump to 18.4% p.a. It has to be somewhere between 10.15% and 12%.

Part C: Modified Investment Strategy
As indicated earlier in Part A, there is one 'problem' with the proposed strategy... and that is 'investing in an NCD'.

It is a known fact that investing in NCDs carries high risk of default. There have been numerous instances wherein the companies that borrowed money by issuing NCDs (or for that matter fixed deposits) defaulted on their obligations. Not only they did not pay the interest, but even the principal amount was gone.

Hence, to ignore the default risk would be a big (big) mistake.

So, I would suggest a slight modification:

Instead of an NCD, you invest your lump sum money (say Rs.12.50 lakhs) in the Post Office Monthly Income Scheme. Since the Govt. of India is not likely to default, this will eliminate the default risk.

At 7.7% p.a. rate of interest, PO MIS will give you Rs.8000 every month. You do SIP in equity mutual funds with this monthly inflow. After 10 years, this investment in equity mutual funds would be worth Rs.18.40 lakhs (assuming 12% p.a. as returns from equity).

This, together with the principal of Rs.12.50 lakhs from PO MIS, will give you a total corpus of Rs.30.90 lakhs after 10 years.

The yield or 'annualized return' of this investment would be 9.47%.

Thus, while keeping your principal safe with the Govt., you can improve your returns from 7.7% to 9.47% by investing the interest income in equity mutual funds thru' SIP.

[Note : Of course, the 7.7% rate of interest on Post Office Monthly Income Scheme is not constant. It can change every 3 months. Whereas interest from the aforesaid NCD is fixed for 10 years. But I would still prefer the risk of variable interest rate in PO MIS compared to the risk of default in an NCD.]

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