Reap from real rate of return
2/23/2012 9:30 PM Thursday
By - Hemant Rustagi
CEO, Wiseinvest Advisors
Investors usually face many challenges through their investment time horizon, such as choosing the right mix of assets and investment options as well as ensuring that investments remain on track to achieve their investment goals. Most of us work out different strategies to tackle these challenges, achieving different levels of success.
One factor that impacts the performance of our portfolio at all times but is seldom given its due is the ‘real rate of return’, i.e. gross returns minus inflation, taxes and costs. Investors tend to focus on ‘gross returns’ and make that the basis of their investment decisions. No wonder traditional instruments like fixed deposits, small savings schemes and bonds/debentures continue to be the mainstay of the portfolios of a large section of the investing public. Although these instruments provide guaranteed returns, these are low and tax inefficient. Needless to say, the real rate of return is either a bare minimum or even negative at times.
Thus, it is evident that apart from choosing the right investment options, it is absolutely necessary to consider factors such as inflation, taxes and costs to improve the real rate of return. Remember, when your investments fail to beat inflation, your money grows only in numbers and not in value.
Let us analyse how each of these factors impact your returns, and what steps you can take to minimise their impact on your portfolio.
Inflation is a crucial factor to bear in mind while investing, as it reduces the value of your investment returns. Broadly speaking, inflation affects all aspects of the economy. From investors’ point of view, the most challenging aspect is to keep up with the rate of inflation in order to protect the value of the investment as well as the returns earned on it.
The impact of higher inflation on an investor’s portfolio would depend upon the composition of his/her portfolio. Therefore, the first step towards achieving a positive real rate of return is to have an investment plan in place. Though it can be quite a challenge to develop a strategy that not only withstands the turmoil in different markets but also helps in achieving short-term as well as long-term investment objectives, you can achieve the desired results by focussing on the correct asset allocation. Another important step that needs to be taken is to curb your expenditure by budgeting them. By doing so, more money will be available for investments every month.
Equities are one of the asset classes that have the potential to beat inflation over the longer term. However, investing in equities would mean taking higher risks as compared to investing in some of the instruments that yield pre-determined or stable returns. Thankfully, there are strategies like ‘systematic investing’ that can help you tackle the risk of volatility to a large extent.
Tax efficiency of the investment options plays a crucial role in improving the real rate of return in the long run. Tax efficiency becomes even more important when one plans to achieve medium to long-term investment objectives like children’s education, buying a house and retirement planning.
Investment options like mutual funds provide tax efficient returns. For example, returns from an investment held for 12 months or more in a debt-oriented fund are taxed at a flat rate of 10 per cent (without indexation) and 20 per cent (with indexation). For investors in higher tax brackets, choosing these options can make a significant difference when compared with traditional options wherein the returns are taxed at their nominal tax rates. Therefore, you must have a ‘tax aware’ investment strategy in place to improve your post tax returns.
Costs are the most ignored aspect of investing. Not many investors realise that an investment in a market-related product that has higher costs makes a serious dent in their returns. The NAVs announced by such products are net of costs. Besides, costs have more impact on debt options than equities. This is because debt options provide lower returns, and since expenses are charged on the overall investment value, the impact on returns can be significant. On the other hand, since equities provide higher returns, the impact of costs may not be much if an investment is held for the longer term.
Therefore, it is important for you to invest in instruments that are cost transparent as well as to consider all costs when deciding the investment mix in your portfolio.
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