The costs of investing

Cost is an important, though poorly understood aspect of investing. It is important for the simple reason that costs reduce the overall return one makes from an investment option. It is also poorly managed as people focus too much on explicit costs (cost of brokerage or fees) and ignore the hidden ones (such as opportunity costs).

As an investor, you have the following few options

a.    Fixed deposit : cost 0, likely return : 8-9% (pre-tax)
b.    Index fund ETF: cost 0.6% to 1%. Likely return : 14-15% (pre-tax)
c.    Mutual funds (HDFC equity fund): cost 2%. Likely return : 20-21% (pre-tax)
d.    PMS: usually 2% of asset and % of gains.  Likely returns: Who knows?

The options

Fixed deposit and index funds are zero or low cost options with the FDs having no volatility, but much lower returns. IF you want to build wealth, an FD is not going to get you there. Index funds are a decent alternative, where the risk of active portfolio management is removed. You don’t have to worry if your portfolio manager is an idiot who will underperform or worse lose money over the long term.

The third option is a well managed, diversified mutual fund with a long operating history. We can quibble about which mutual fund to choose, but I prefer one which has been conservatively managed for a long time. HDFC equity has been around since 1995 (almost 20 yrs) and has delivered good performance over the years. I am not recommending HDFC equity fund, but using it as an example of a well managed fund which has returned above average returns over the long term.

The last option is private vehicles such as PMS (portfolio management schemes). These involve high costs, and in some cases deliver good returns. However they have a mixed record and are generally not a good option for most investors due to a high minimum investment.

The math

Let’s take a hypothetical case

Let’s say you have 9 lacs to invest. It is Jan 2011 and you are looking for some avenues. You decide to invest equally in the three choices I have discussed above (lets ignore PMS for the time being)

At the end of 3.5 years, you will have following sums with you
Fixed deposit (pre-tax): 4.05 Lacs (pre-tax) and 3.84 Post tax
Index fund (pre-tax and post tax): 4.18 Lacs (net 1% as cost)
Mutual fund (pre-tax and post tax): 4.62 lacs (net 2% management fee )

The last 3.5 years have not been really that great for the stock markets (around 10% CAGR). Inspite of that, the index fund was able to do better than the FD on a post tax basis. The same held true for a well managed mutual fund too.

The explicit costs
In order to make the higher returns, an investor had to contend with all the volatility and noise in the market. In addition to the emotional toll, there was an explicit cost of around 3% for the index fund and around 6% for the mutual fund.

Most investors tend to ignore these costs unless it is pointed out to them. If someone  told them upfront that a 3 lac investment in a mutual fund would cost them 18000 over three years, they would balk at it and run towards FDs , real estate or gold.

Inspite of these costs, if an investor could stomach the volatility, he or she came out ahead during one of the lousy periods in the stock market.

Implicit costs

If you think explicit costs are bad, I would say the hidden costs are even worse.

So what is the hidden cost for an FD? It’s the opportunity cost to create wealth. In the above example an FD would cost 20% more than a mutual fund over a 3-3.5 year period (difference between the amounts after 3.5 years between the two options).

This difference only increases over time and would be even wider once the market performs close its long term average (15-17%) and interest rates drop.

I am sure I will get a counter point – how about real estate or gold. Let’s look at each of them –

If you bought 3 lacs of gold in Jan 2011, you would have around 3.78 Lacs of gold now (at pre-tax). I don’t want to discuss taxes as paying taxes on gold is different issue altogether. So gold did barely as well as an FD. Keep in mind that gold over a 20 year or longer period has delivered 9-10% per annum despite the recent runup (excluding transaction and holding costs)

Let’s move onto the next darling – real estate. So what returns can one get here? Well all of us have stories about how person xyz made 10X the capital in 5 years. Well, that is the equivalent of saying some investors made 20X their capital in page industries.

The returns on a specific investment – a stock or a property is not same as the return of an entire investment class. If you want to look at the average returns, look at this table by NHB. The returns vary from -15% for a Kochi to 249% returns for Chennai over a 7 year period. So we are talking of -2% to 15% per annum for different locations. This does not even include taxes, brokerage, and maintenance fee (For property).

Now the final argument would be – I was able to find a property and invest in it for a 10X gain in the last 5 years !

Congrats – but then you are missing the final point. The final point is the cost of time and effort – if you are a full time or even a part time investor in RE, you are using knowledge/ skill/ time to dig out such deals and investment in them. As you do this, you are not using your time do XYZ (spend time working, with your kids, play – whatever you can think of)

Compare all costs
IF you truly want to compare multiple investment options, compare all the costs – implicit and explicit

The explicit costs are fees and taxes. These are generally obvious and laid out to an investor (though still ignored). The implicit costs are usually hidden and often bigger – they are the opportunity costs of money (not investing in equity) and of time (spending time on investing versus other pursuits)

It is foolish to look at some costs and declare a particular option as better. Maybe I value peace of mind and time with family more than returns – in that case an FD is better.  My own dad valued these attributes more than returns and spent his spare time with his kids and on his own hobbies (without ever depriving us of anything in life)

On the other hand, there are people like me who love the process of investing and enjoy the higher returns. In my case, the vehicle is stocks and some other cases, it is real estate. There is an implicit cost  (time and energy) involved in earning the higher returns, which we don’t mind incurring, but it is a cost all the same (my wife can vouch for it !)

In addition to these costs and corresponding returns, I would say there are emotional and bragging benefits to various options which will be the subject of the next post.