September 7, 2009

Retirement planning – Risk and return

I do not plan to layout a template which can be followed step by step to plan for retirement. It would be difficult to do that as individual circumstances vary and so would the solution. My attempt in this post and the next would be to layout my thought process on various factors for retirement planning which can be used to think through and execute a plan.

Risk and return
The starting of risk and return should be risk and not returns. One should not start with a return target of x% and then work out the investment plan. On the contrary, it is important to look at your risk tolerance and how much time you would have to cover losses, if any.

Risk tolerance in turn is a difficult and subjective topic. What is risky for me, may be low risk for you. As a result, risk should be analyzed from a personal perspective. I personally do not follow the typical risk measures of beta and other such academic concepts.

I look at risk as doing something without the knowledge and experience to do it, especially where I do not have a clear view on how much I can lose in the worst case scenario. Lets explore that point further - Lets say I wish to invest for my family in such a way that they are able to get a return of 10-12% over 3-5 year period. It is easy to get around 8% through FDs and other such fixed income instruments. In order to get the extra 2-3% per annum, I need to look at equity to improve the returns.

My own personal experience and the last 10-25 yr data shows that the BSE index has returned between 12-15% per annum over the long term. However at the same time, this average return has been marked by 30% drops and 40% increases too. So in this case I can look at index funds as a possible option as I have a rough idea of the risk and return profile.

Now suppose someone suggests that I should invest in gold or real estate as these are good hedges against inflation. I would hesitate for multiple reasons

- I have never invested personally in these asset classes for investment purpose.
- There is lack of enough long term information and transparency in case of real estate (or atleast I do not have access to it)
- Gold has not provided good long term returns over the last 20 yrs. Now the next 10 yrs could be different and there seem to be a lot of pundits saying so, but I don’t have the data to validate it and hence would stay away from it.

In a nutshell, risk for me is a lack of understanding the investment option in terms of the long term return and the maximum possible loss under various scenarios.

Expected returns
The next aspect of investment planning is returns. Returns are closely tied with the level of knowledge and sophistication one can bring to the process of investing. Let’s look at some scenarios

The know nothing investor – you have no idea of investing and have never invested in the stock market. Your idea of a bull market is the bull or cow you may have seen in a local indian market J. A person who has no idea of even the basics of investing should look at investing in bank FDs and look at 7-8% returns. Such an individual when planning for retirement for self or for parents should not go beyond these FDs. There is however a risk for such an investor too. The risk is inflation. As the investor is barely earning 1-2 % above inflation (or even less), there is serious risk that the investor would not be able to support himself with the excess 1-2% returns over inflation. If the investor draws any more than 3% of the capital per annum for expenses, he or she will run out of money in due course of time

The beginner – you have some idea of investing. You have invested a little bit in mutual funds. You typically watch CNBC and think the anchors are dispensing good advise. Your idea of the stock market is that this place is like a casino where you can make it big or lose money big time. A person at this stage is at the highest risk of losing his or her capital. Half knowledge is always dangerous. A person at this stage needs to decide whether he is ready to invest the time to learn more about investing. If this person is not ready to invest the time and energy to do so, then the best option for such a person is to invest a small portion of his capital every month in a good index fund (via a systematic investment plan) and the rest in bank FDs. If the person is able to keep a 40-60 asset allocation (40% in equities), he or she can expect 10-11% returns over the long term.

The key issue for such an investor is that he or she needs to start saving and investing early in life and reduce the equity allocation to a max of 20% after retirement. I would not recommend an equity exposure (via index funds) of more than 20% of capital for anyone in this group who has crossed retirement.

The sophisticated investor – This kind of investor has been investing for the last 6-7 years. He or she has seen 1-2 bear market and has not been scared by it. He understands the risk involved in investing and has a fair amount of risk management skills. If you parents fall in this bucket, I doubt they would need your help.

If you are planning your own retirement and have 15-20 years to go, then you are in a good position. A 60-70% allocation in equities can be maintained. A 30-40% investment in stocks with the rest in good mutuals or index funds can be built via a systematic investment plan (investing a fixed amount of money each month).

This kind of investor needs to keep the long term in mind and should avoid a short term approach of performance chasing. The risk of losing capital for an extra 2-3% is fairly high and should be avoided. An investor in this group can expect around 13-15% return in the long run and if he or she starts an investment program early, should be able to retire very comfortably

The expert or the guru – This kind of investor has been investing for more than a decade. He or she has beaten the pants out of the market (in excess of 20%). If you parents are in this group, congratulations !!. They will take care of your retirement :)

If you fall in this group, I am not sure why you are reading this post. A person in this group has no reason to think or worry about his or her retirement. Any one who can compound money in excess of 20% can retire a very rich man ( for ex: such a person can convert 100000 to 40 lacs in 20 years). A person in this category can manage money for others and become seriously rich before his or her retirement.

Various instruments
In the above discussion I have discussed about fixed income instruments and equities. You would have noticed a lack of discussion about other assets such as real estate, gold, commodities, options etc. Let me share some thoughts on the various asset classes below

fixed income : One can expect returns in the range of 6-8% and low risk. Typical options are bank FDs, Post office deposits and debt mutual funds. All these options are low to very moderate risk and good for the first two group of investors (the know nothing and the beginner)

Equities : One can expect returns in the range of 12-14 %. Typical options are index funds and mutual funds. This option has moderate to high risk and should be handled with care. A beginner should look at only index funds or some good mutual funds. A sophisticated investor can look at stocks as long as he or she knows what they are doing. A lot of investors and financial planners would like to assume that equities can returns in excess of 20%. However the indian markets over the last 15-20 yrs (a typical retirement planning horizon) have returned around 13-14% and I would not like to assume anything more than that when planning for retirement.

Real estate : This asset class has become a hot favorite in the last few years. However the long term history of real estate across the world and across time horizons is that the returns from this asset class are 1-2% lower than equity. If you are beginner or a know nothing investor, I would really not look at putting money in real estate (other than for primary residence). This is an illiquid asset class with lack of transparency in india. If you are a sophisticated investor, then it may be possible to get a fair return, but then one has to be ready to spend the required time managing it too. I have written about real estate
here in the past

Gold, commodities, and options – I have clubbed all these options on purpose. If you are a know nothing or beginner, I would stay away from these assets as far as possible. In these categories I will buy gold when I am buying jewelry for my wife and commodities when I need sugar or wheat for my kitchen :). The only group which should invest in these assets should be the experts. I would even say that sophisticated investors should not look at these assets for long term investing. If you need an ego boost, invest a little bit for fun, but If you are not an expert, you can get you’re a** kicked big time in the market.

If the above post has not put you to sleep already, then the next one will surely do it :) I plan to cover the following topics – asset allocation, admin tasks, portfolio rebalancing and finally putting it all together


Aniruddha said...

good article.

Thanks Rohit

Lucky said...

Wow!!! Another gem!

You have unending patience Rohit. And you care a lot. Thanks a ton...

I fall in the beginner category by your standards. Yet to see another bear market or two before I turn "sophisticated."

I am not sure about the inflation one should assume. I am terribly scared by this monster and assume something like 9-12% (real inflation).

So effectively one cannot expect to beat the inflation by more than 5-6%. Not bad, if one starts early.

But assuming that the fixed income returns are always same as or less than the inflation, what role they should play in a "sophisticated" portfolio?


sumi said...

I like the last bit about buying gold for you wife and wheat and sugar for your kitchen :) I have started investing since May so I still have a long time to go before I get into the sophisticated category. What I can gather from this post is that I should be putting a portion of my savings in index funds which earlier I have not considered. I haven't read about funds earlier on your blog. I only invested directly. Will need to read up and discuss a lot before I actually go ahead with an index fund. It would be nice if you posted something on them in the future once you finish all the remaining posts you have planned.

Anonymous said...

As always U have provided a nice writeup on the big picture of retirement planning. And nice thought process too!!

Can anybody suggest some resources (blogs, books etc.) to learn about these topics:
=> Investing in Commodities
=> Forex trading
=> Derivatives trading
=> Real Estate

Side note: I doubt there would be any blogs/sites on the above topics which are as good as Rohit's blog on equity investment, but even half as good would work :-)


Anonymous said...

Its funny!

This is almost like an echo for me. I have identical thoughts on the issues discussed in this article.

I think one thing you missed out are ETF's. Incl. gold ETF's these are straightforward funds which you can buy and sell in the market. They give you a lot of advance notice in case you want to redeem and exit.


Rohit Chauhan said...

Hi lucky
inflation is truely the biggest risk for the fixed income investor. let me try to answer your question in the next post.

Hi sumi
you can read my posts on mutual funds under the category 'mutual funds'


Rohit Chauhan said...

Hi raj
thanks for your comment. in all areas outside equities and to a certain extent fixed income investing ..i am a know nothing guy.

as i said, the only time i see commodities is when i do grocery or forced to buy jewelery for my family :)

for me there is a lot to do in equities and the returns have been very good , that i have not yet felt the need to look at other asset categories. i have recently started reading these other asset group and only have a very cursory idea of these asset classes.

i think a few other readers of this blog may be able to answer your question


pritchie said...

Great article, overall I completely agree with your recommendations. A few comments however.

1. Your 12-15% number for equities seem high to me.

If I look at 10 year compound rates for the DJIA from 1980-2007 I get similar numbers (average of 12%*).

* These numbers do not take into account reinvestment of dividends.

But when I do the same for 1900-2007 the results drop to an average of roughly 5%*.

Regardless, the key item when planning retirement is that your savings not be eaten into by inflation. Using fixed percentages can be dangerous, as it can lead to misplaced confidence.

For example: an 8% return is perfectly acceptable if inflation is 2-3%, but disastrous if it is 10-12%.

2. You stated explicitly above that FDs provide protection of capital but little real return, however you didn't outline the parallel for equities.

The advantage of equities is that they should provide long term returns approximate to GDP growth + inflation. Unfortunately equities also come with a good deal of volatility.

The whims of Mr. market are the enemy of the beginner but the friend of the expert.

Retirement planning for beginners is all about managing the psychological pain that comes from volatility.

As such, shouldn't a know nothing investor with a long term horizon and the capacity to handle the volatility have at least a portion of his savings in an index fund to help combat inflation?

Vikas Rana said...

Excellent post Rohit. Keep it up.

Anon2: Yes, ETF is a great alternative to Index Fund but doesn't allow SIP.


Rohit Chauhan said...

Hi pritchie
thanks for the comment. my bad, and i should have stated clearly - the equity returns for the indian market - BSE returns.

the point you make about % allocation is true and i plan to tackle that in the next post via asset rebalancing / reallocation.

In case of fixed income investing my assumption is that the instruments will give you 2-3% above inflation. if the inflation rises suddenly , then you may lose out for sometime, but duration of the instrument is not too long ..then it should be fine when you renew your FDs..also laddering can be used to take care of it. finally one can buy variable rate funds to reduce the risk.

on the issue of volatility i am not sure if a know nothing investor will have the fortitude to absorb 20-30% drops in value in the short term. even those who have been around get nervous

Rohit Chauhan said...

Hi anon2
i differ on the point of ETF ..if you believe in gold as an asset class then ETF is a good vehicle for it..but if like me you dont have too much faith on it (not withstanding the recent history), then the whole point of using an ETF is moot


Rohit Chauhan said...

Hi anon2
i differ on the point of ETF ..if you believe in gold as an asset class then ETF is a good vehicle for it..but if like me you dont have too much faith on it (not withstanding the recent history), then the whole point of using an ETF is moot


sachin8778 said...

Hi Rohit,

Congratulations for another great post.. keep it up.

I need some further inputs on real estate. I moved into my new house and rented the old flat. Though I have not looked at old flat as a typical investment but when I think of my net worth for rainy day it is very much counted in it. As rent income, it is giving me about 5% returns and I hope the value of the asset too is growing and will grow keeping pace with inflation. But as you said it is bit illiquid and volatile too.

Pl suggest if there is any merit in liquidating it to use the sum for investment in Equity (through mutual funds keeping asset allocation suiting my risk appetite i.e. 65% Equity). I am more comfortable with Mutual funds since I don't think of myself as sophisticated yet, even though I have confortabley witnessed the recent cycles :)

Thanks in advance.

Anonymous said...

Hi Rohit,

Again I differ with you. ETF's offer the convenience of a liquid asset traded at the exchange. One can apply very simple principles of buying at very low rates and selling when the markets awaken to the value of ETF's. I am based out of the US and so in this climate where dollar is offering almost safety..the convenience of Gold ETF's cannot be denied. It does not require much SME too...

BTW, I found this link which was helpful to me and might help someone else too..


Lucky said...

Hi pritchie,

Where did you get the data for 1900-2007 from for the Indian market?

Will it be possible for you to share it?


pritchie said...

1900-2007 data was for the Dow Jones Industrial Average, so it's the US market.

Rohit Chauhan said...

Hi sachin
i am sorry to say this, but i dont offer personal investment advise. its not possible for me to know all the details of a situation and a bad advise can harm more than help.

hi anon2
i am not against any specific asset class. smart people can make money out of almost anything ..what is required is the knowledge, skill and effort for doing it well.

if you know gold ..then more power to you. if you however you are novice or newbie then it is not good to try alternative classes before you figure them out - that is my point

sachin8778 said...

Sounds good.. thanks.

Anonymous said...