29 Nov 2024

The impact of “taxed at slab” — Take 2

I had a review call with my financial advisor yesterday. I expressed my desire to invest in debt-like mutual funds that are not pure bond funds to avoid paying tax at the slab rate. The advisor wasn’t particularly excited. He wanted me to invest in gilt funds to avoid credit risk and liquidity risk (which are more in corporate bonds than sovereign bonds).

While I understand that he does not want to recommend a risky asset to a client, I am also hesitant to lose money to tax when sufficiently good alternatives exist. After the meeting, I decided to run the numbers to quantify the difference in the final corpus while paying 30% tax vs 12.5%.

The results are not surprising. Once the holding period gets close to 10 years, the difference in the final corpus rises close to 10%. Holding for shorter durations, say 5 years or 8 years, it’s probably not a bad idea to stick to pure bond funds. For shorter durations, we get safety without much of a loss in the final corpus.

The following tables show the comparison for various holding periods and assumed annual growth rate. These calculations assume an initial investment of ₹1,00,000, but the delta percentage will remain the same irrespective of the principal amount.

PS: ‘Tax at slab rate’ has been a problem for me for a while now. My previous calculation did a similar comparison for higher growth rate and shorter holding periods.

Num of years ➡3 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 1,14,117₹ 1,12,352₹ 1,09,8822.2%
5.0%₹ 1,15,763₹ 1,13,792₹ 1,11,0342.4%
5.5%₹ 1,17,424₹ 1,15,246₹ 1,12,1972.6%
6.0%₹ 1,19,102₹ 1,16,714₹ 1,13,3712.9%
6.5%₹ 1,20,795₹ 1,18,196₹ 1,14,5563.1%
7.0%₹ 1,22,504₹ 1,19,691₹ 1,15,7533.3%
7.5%₹ 1,24,230₹ 1,21,201₹ 1,16,9613.5%
8.0%₹ 1,25,971₹ 1,22,725₹ 1,18,1803.7%
8.5%₹ 1,27,729₹ 1,24,263₹ 1,19,4103.9%
9.0%₹ 1,29,503₹ 1,25,815₹ 1,20,6524.1%

Num of years ➡5 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 1,24,618₹ 1,21,541₹ 1,17,2333.5%
5.0%₹ 1,27,628₹ 1,24,175₹ 1,19,3403.9%
5.5%₹ 1,30,696₹ 1,26,859₹ 1,21,4874.2%
6.0%₹ 1,33,823₹ 1,29,595₹ 1,23,6764.6%
6.5%₹ 1,37,009₹ 1,32,383₹ 1,25,9064.9%
7.0%₹ 1,40,255₹ 1,35,223₹ 1,28,1795.2%
7.5%₹ 1,43,563₹ 1,38,118₹ 1,30,4945.5%
8.0%₹ 1,46,933₹ 1,41,066₹ 1,32,8535.8%
8.5%₹ 1,50,366₹ 1,44,070₹ 1,35,2566.1%
9.0%₹ 1,53,862₹ 1,47,130₹ 1,37,7046.4%

Num of years ➡10 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 1,55,297₹ 1,48,385₹ 1,38,7086.5%
5.0%₹ 1,62,889₹ 1,55,028₹ 1,44,0237.1%
5.5%₹ 1,70,814₹ 1,61,963₹ 1,49,5707.7%
6.0%₹ 1,79,085₹ 1,69,199₹ 1,55,3598.2%
6.5%₹ 1,87,714₹ 1,76,750₹ 1,61,4008.7%
7.0%₹ 1,96,715₹ 1,84,626₹ 1,67,7019.2%
7.5%₹ 2,06,103₹ 1,92,840₹ 1,74,2729.6%
8.0%₹ 2,15,892₹ 2,01,406₹ 1,81,12510.1%
8.5%₹ 2,26,098₹ 2,10,336₹ 1,88,26910.5%
9.0%₹ 2,36,736₹ 2,19,644₹ 1,95,71510.9%

Num of years ➡15 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 1,93,528₹ 1,81,837₹ 1,65,4709.0%
5.0%₹ 2,07,893₹ 1,94,406₹ 1,75,5259.7%
5.5%₹ 2,23,248₹ 2,07,842₹ 1,86,27310.4%
6.0%₹ 2,39,656₹ 2,22,199₹ 1,97,75911.0%
6.5%₹ 2,57,184₹ 2,37,536₹ 2,10,02911.6%
7.0%₹ 2,75,903₹ 2,53,915₹ 2,23,13212.1%
7.5%₹ 2,95,888₹ 2,71,402₹ 2,37,12112.6%
8.0%₹ 3,17,217₹ 2,90,065₹ 2,52,05213.1%
8.5%₹ 3,39,974₹ 3,09,978₹ 2,67,98213.5%
9.0%₹ 3,64,248₹ 3,31,217₹ 2,84,97414.0%

Num of years ➡20 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 2,41,171₹ 2,23,525₹ 1,98,82011.1%
5.0%₹ 2,65,330₹ 2,44,664₹ 2,15,73111.8%
5.5%₹ 2,91,776₹ 2,67,804₹ 2,34,24312.5%
6.0%₹ 3,20,714₹ 2,93,124₹ 2,54,49913.2%
6.5%₹ 3,52,365₹ 3,20,819₹ 2,76,65513.8%
7.0%₹ 3,86,968₹ 3,51,097₹ 3,00,87814.3%
7.5%₹ 4,24,785₹ 3,84,187₹ 3,27,35014.8%
8.0%₹ 4,66,096₹ 4,20,334₹ 3,56,26715.2%
8.5%₹ 5,11,205₹ 4,59,804₹ 3,87,84315.7%
9.0%₹ 5,60,441₹ 5,02,886₹ 4,22,30916.0%

Num of years ➡25 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 3,00,543₹ 2,75,476₹ 2,40,38012.7%
5.0%₹ 3,38,635₹ 3,08,806₹ 2,67,04513.5%
5.5%₹ 3,81,339₹ 3,46,172₹ 2,96,93714.2%
6.0%₹ 4,29,187₹ 3,88,039₹ 3,30,43114.8%
6.5%₹ 4,82,770₹ 4,34,924₹ 3,67,93915.4%
7.0%₹ 5,42,743₹ 4,87,400₹ 4,09,92015.9%
7.5%₹ 6,09,834₹ 5,46,105₹ 4,56,88416.3%
8.0%₹ 6,84,848₹ 6,11,742₹ 5,09,39316.7%
8.5%₹ 7,68,676₹ 6,85,092₹ 5,68,07317.1%
9.0%₹ 8,62,308₹ 7,67,020₹ 6,33,61617.4%

Num of years ➡30 years
Growth rate⬇ / Tax rate ➡Pre-tax corpus12.5%30.0%Corpus delta
4.5%₹ 3,74,532₹ 3,40,215₹ 2,92,17214.1%
5.0%₹ 4,32,194₹ 3,90,670₹ 3,32,53614.9%
5.5%₹ 4,98,395₹ 4,48,596₹ 3,78,87715.5%
6.0%₹ 5,74,349₹ 5,15,055₹ 4,32,04416.1%
6.5%₹ 6,61,437₹ 5,91,257₹ 4,93,00616.6%
7.0%₹ 7,61,226₹ 6,78,572₹ 5,62,85817.1%
7.5%₹ 8,75,496₹ 7,78,559₹ 6,42,84717.4%
8.0%₹ 10,06,266₹ 8,92,982₹ 7,34,38617.8%
8.5%₹ 11,55,825₹ 10,23,847₹ 8,39,07818.0%
9.0%₹ 13,26,768₹ 11,73,422₹ 9,58,73718.3%

25 Nov 2024

Bank deposits vs debt mutual funds

Bank Deposits vs Debt Mutual Funds is a false dichotomy. One is not a replacement for the other. Most of us need both. Yet, people constantly compare them because they both seem to serve the same purpose.

A bank deposit is a way to hold cash. Holding cash means it’s for a short-term need (which includes potential short-term needs such as an emergency fund).

A debt mutual fund is a way to add stability to a long-term investment portfolio. It’s main purpose is not to hold cash, but to act as a shock absorber.

Slide from a recent talk I gave on debt mutual funds (click to enlarge)

Bank deposits shield you from the capital loss risk. Scheduled commercial banks regulated by RBI have never lost a single rupee of depositor money. The confidence investors have with bank deposits is well-earned and well-deserved. However, capital loss is not the only thing an investor should be considering.

Disclosure: I am biased against bank deposits. Please keep that in mind when you read the rest of this post. I try to be objective, but knowing my bias can help you make a better decision for managing your own money.

Concentration risk

You may trust your bank with a small sum. You may feel confident that they’ll return the money when you ask for it. But there is a point at which you start to feel uncomfortable. That number could be a few lakhs for some and a few crores for others. But we all start to feel jittery when the size of the deposits grow beyond a certain size. Debt mutual funds alleviate this concentration risk by deploying our money in dozens of different securities.

Tax drag

You may make a deposit that pays 8% return on your deposits. But if you are in the 30% tax slab, your effective return is only 5.6% after paying tax every year. Someone with a sizeable fixed income portfolio can save a significant sum just by avoiding tax payments every year.

Let’s think of a hypothetical bank deposit that pays 8% return and compare it with a hypothetical debt fund that appreciates by 8% per year. Imagine an investment of ₹1,00,000 made by an investor who falls in the 30% tax slab. At the end of 10 years, the bank deposit would have grown to ₹1,72,440 (after taxes). The same principal would have grown to ₹1,81,124 (after taxes) if invested in our hypothetical debt mutual fund.

While this ₹9,000 may not look like much, the difference becomes more pronounced with longer holding durations. For 25 years, the final corpus values are ₹3,90,479 and ₹5,09,392 for bank deposit and debt mutual fund respectively. (If 25 years sounds unrealistic, ask yourself: how long does your retirement portfolio need to last?)

Chart showing after-tax corpus value of bank deposit vs mutual fund after 10, 15, 20, and 25 years
Chart created at canva.com

Manual vs automatic

Bank deposits are too manual, and require maintenance. Every time you have money to invest, you need to decide whether to make a 1 year deposit or a 5 year deposit. If you get that duration wrong, you may need to pay a penalty when you prematurely withdraw your bank deposit. Every time you need to take money out, you need to decide which deposit to liquidate. No such hassle with debt mutual funds. You invest and redeem as and when you need; no penalty for misjudging when you need the money.

Bank deposits are a great source of FOMO (fear of missing out) when interest rates rise. Many people had made bank deposits during Covid when the interest rate was low. When the RBI hiked interest rate, they all had a conundrum—whether to prematurely close their previous deposit or not. No such hassle with a debt mutual fund. Your money will earn “market interest” irrespective of whether the rate rises or falls.

Better visibility of where your money is

If you invest in a debt mutual fund, the AMC will disclose the fund’s portfolio with you every 14 days. You can clearly see how much of your money is lent to whom. If you don’t like what you see in that list, you have the power to move your money to a different fund.

With bank deposits, the traces of “your money” is completely lost. Your money becomes a part of the very large pool of liabilities that the bank has. That is not necessarily a huge risk considering that banks have not lost depositor money. But something for you to consider and decide what makes you feel better.

Potential to take higher/different risks

There are many different categories of debt mutual funds that let you choose exactly what you want. Do you want to avoid credit risk as much as possible? Invest in a gilt fund. Do you want to earn a bit more return by lending to private borrowers? Invest in a corporate bond fund. Do you want an asset that’s as close to a bank deposit but in the form of a mutual fund? Invest in a liquid fund. (Disclaimer: quality of funds can wildly vary within every category.)

So many debt mutual fund options exist because different investors want different assets for their portfolios. Bank deposits, on the other hand, are all the same: you deposit money today, and the bank returns it after the agreed upon time has elapsed.

What is the flip side of this? It is possible for an investor to pick a wrong mutual fund that doesn’t suit them; no such risk with bank deposits because they are all the same.

• • •

All these differences should tell you where each asset fits: bank deposits are to hold cash. You don’t care about optimising the return; you pay a high tax for the capital preservation safety; you pay an inconvenience fee to the bank in case you change your mind and want your money back prematurely.

Debt mutual funds are for long-term holdings. You don’t really need that money in the next few years; you appreciate the bouquet of options that you can choose from; you are willing to reduce the capital preservation safety by a tiny bit in exchange for letting a fund manager manage the money.

One is not a replacement for the other because they serve different needs. Choose what works for you based on what you need, and what makes you feel at ease.

Fund benchmarks hint at fund portfolios

Hybrid mutual funds are a little tricky to evaluate. Not only do you have to understand the strategy the fund will follow, but you also have to know the asset allocation that the fund will maintain. The fund’s scheme information document holds the authoritative answer for how the money is invested, but the benchmark chosen by the fund can give a quick hint on what to expect. I use benchmarks as an early signal to filter out funds that may not be suitable for my needs.

Let us look at a few examples of multi asset allocation funds. All the following screenshots are from ValueResearchOnline. I will not name the funds because identifying individual funds is not necessary for this exercise, and I don’t want to give unintentional signals (positive or negative) about any specific fund.

This is a popular mix of assets: 65% equity qualifies the fund to be taxed like equity. That may sound attractive to many investors, but I generally avoid such funds because I reach for hybrid funds only when I want to keep volatility low.

This is an interesting one, and honestly an appealing choice for me. This fund is well diversified with a global equity index and a commodity index added to the benchmark. (This is the first time I am even looking at this fund, actually.)

This is a simpler fund with just 3 asset classes in the benchmark. I also like that A-II debt is the largest asset class in the benchmark, which is a good hint that this fund will be less volatile than many of its peers.

While benchmarks give us a good hint on how the fund will invest our money, it is crucial to look at other sources of information, too. Reading the scheme information document, looking at the history of the fund (if available), and the history of the AMC (if available) can give us valuable information on what to expect from the fund.

21 Nov 2024

Why is volatility of investment assets bad?

Here are some samples of recent price movements of the Alphabet share (GOOG).

  • Between 28-Aug-2020 and 25-Sep-2020, the price of GOOG fell from $82.22 to $72.25. That’s a fall of 12.13% in 29 days.
  • 2022 was particularly volatile.
    • Between 25-Mar-2022 and 29-Apr-2022, the share price fell from $141.52 to $114.97. A fall of 18.76% in 36 days.
    • In the next 50 days, it fell 6.18% further to reach the price of $107.87 on 17-Jun-2022.
    • In the next 57 days, the price rose by 13.70% to $122.65 on 12-Aug-2022.
    • In the next 85 days, the price fell again to $86.70—a fall of 29.31%.
  • Between 5-Jul-2024 and 6-Sep-2024, the price fell from $191.96 to $152.13. A fall of 20.75% in 27 days.
5 years price graph of GOOG at the time of publishing

I used to not worry about volatility. If the price anyway appreciates after a fall, I used to think, just wait for the price to go up. Why try to reduce or avoid volatility? That’s how I used to think, but experience has changed my stance.

I hold some Alphabet shares (GOOG). Twice in my life, I have wanted to sell these shares for important and time sensitive needs. Both times, GOOG had fallen badly. Once I sold the shares at a low price; the other time I had to arrange money through different means.

Volatility is bad if you expect to use the asset. If you need to sell a volatile asset in the next few months, you have no idea what price you will get. If you pledge a volatile asset to take a loan, you have no idea when the margin will be too low and you may need to sell the asset at a low price.

But someone who doesn’t really need to use the asset has no reason to worry about volatility.

In practical terms, the advice may boil down to this:

  • Sell your volatile assets much before you need the cash. For individual company stocks, having a runway of a few years will (hopefully) give you enough opportunities to sell the stocks in batches to accumulate cash.
  • Having a clear idea of how much money you need for consumption—your life goals such as retirement, children’s education, etc—can be very helpful. You need a strategy to manage volatility of the money you need. The money that you don’t need can be held as volatile assets without a worry.

11 Nov 2024

Drawdown of the Nifty 500 Value 50 index

The theory is that value stocks have a margin of safety, and hence, they tend to fall less. Intuitively, if you already buy stocks that are priced lower than their worth, how much more can they fall? They should fall less than stocks that are priced more than they are worth.

Investopedia also says the same:

Value stocks are at least theoretically considered to have a lower level of risk and volatility associated with them because they are usually found among larger, more established companies. And even if they don’t return to the target price that analysts or investors predict, they may still offer some capital growth.

However, the Nifty 500 Value 50 index has historically fallen more than the broad market Nifty 500 index. 

Image source: ETMoney’s Instagram post

I have thoughts on why this could be, but they are mostly just opinions rather than facts with data to back them. I’ll just say one thing: don’t invest in this Value index if you prefer to avoid large drawdowns.

PS: Also, don’t think that this index usually does better than Nifty 500. The rolling return data on the 5th image of the same ETMoney post makes it clear that the Nifty 500 index is a lot more reliable.