Discipline determines the size of your retirement corpus

I am working with a financial planner, and they did some math to make sense of my current portfolio’s value. I knew how many rupees my portfolio was worth, but I didn’t know how many of my financial goals this money was good for. The planner’s way of looking at the corpus gave me a fresh look at the portfolio.

Let’s say the value of my current corpus is X. In about 21 years, I need a retirement corpus that’s at least as large as 3X. Assuming an average annual return of 10%, my existing corpus will double in about 7 years. If I left this corpus of X untouched for 21 years, I’ll have 8X by the time I retire! Such a corpus will be sufficiently large for the kind of retirement I want to have: the kind where I am free to travel, have sufficient buffer for unexpected emergencies, generously spend on life events of children and grandchildren, etc.

While this corpus grows in the background, I’ll also be making fresh investments in the next 21 years. All the new investments that I’ll be making towards retirement in the next 21 years will only grow to X. It’s almost unbelievable how little my new investments will amount to (X) vs how much the existing corpus will grow to (8X).

My main takeaway from this newly acquired knowledge is not that I’ll have an easy retirement. The main takeaway is that I should be financially disciplined enough that I am able to manage my day-to-day expenses and other financial goals without touching the current retirement corpus. The corpus will  have a chance to multiply manifold only if I leave it alone and let it grow.

‘Discipline’ by Nick Youngson • CC BY-SA 3.0 •  Pix4free.org

With this revelation, I am able to appreciate the truth behind the saying ‘a bird in the hand is worth two in the bush’. The corpus I already have is precious, and I must do what it takes to protect it. Staying disciplined for the next 21 years is far more important than asset selection or timing the market or chasing current trends. Even if I invest all the new money in an amazing product that gives higher return, it’s going to be incredibly hard to beat my existing corpus.

I always knew that investment duration was a critical factor. But seeing the math for my own corpus makes it all the more real. Discipline is hard when it’s a vague belief. Discipline becomes easier when you know it’ll enrich your life.

Infographic of debt mutual fund durations

Whenever I want to see durations of debt mutual funds, I have to do a Google search, pick a result, and read through some text before I can understand how the debt fund durations stack up. I thought I’d make an infographic so it’s easy to see where each category falls on the spectrum. (I used Groww as the information source.)

The image is not to scale, though many of the boxes should be of a proportional height. Click on the image to magnify it.

Infographic showing durations of debt mutual funds; click to make the image larger

When choosing a debt mutual fund, consider both credit risk and interest rate risk. A few previous posts on debt mutual funds:

• Should I invest in short term debt funds or long term debt funds?
• Visualising how interest rate movements affect debt fund yields
• Open-ended target maturity debt funds are an excellent choice
• But why is volatility in debt investment bad?

Some basic ideas of investing

• Investing is just buying, holding, and selling assets.
• Cash is a depreciating asset. Cash depreciates in value over time due to inflation. Other assets such as cars and buildings depreciate due to material depreciation.
• Appreciating assets are a good investment. Depreciating assets are a bad investment.
• Bank deposits are cash. They depreciate like cash, just as liquid as cash, and deposit interest is taxed like cash.
• Price of your assets may change every day… or many times within a day. You don’t need to keep watching every price movement.
• You don’t look at the current market value of your gold jewels or house every week. Treat your stock and mutual fund assets the same way.
• Different assets have different behaviours. Understand your assets before buying them.
• Will this asset appreciate over time, or will it depreciate?
• How hard/easy will it be to sell this in the future, if/when I decide to sell?
• Will I find buyers when I want to sell this in the future?
• How will this asset make money?
• For example, real estate assets provide rent, stocks pay dividends, etc.
• How might this asset lose money?
• For example, cars lose value to depreciation.
• Diversification reduces risk. But it also reduces your maximum return. Another way to look at this is that diversification shields you from extremes, be it extreme loss or extreme profit.
• It’s natural to want extreme profits while wanting to avoid extreme losses. Choose the right amount of diversification for your portfolio considering its benefits and risks.

Should I invest in short term debt funds or long term debt funds?

I was listening to the Paisa Vaisa podcast on Trust AMC and got a better understanding of how mark-to-market pricing helps or hurts bond investors.

Mark-to-market pricing

Let’s imagine there are 2 mutual funds: 2YBF that invests in bonds that mature between 1 and 2 years and 1YBF that invests in bonds that mature in less than 1 year. Imagine a period of 1 or 2 years where the interest rate remains constant.

2YBF buys a 2-year bond that pays coupon (interest) of 4.5% per year. At the same time, 1YBF buys a 1-year bond that pays coupon of 4%. Remember these market rates; we’ll use these numbers later.

By the time the first year ends, the bond held by 1YBF would have matured and 1YBF will need to buy a new 1 year bond. The bond held by 2YBF is 1 year old and matures in a year from now. 2YBF cannot  invest in bonds maturing in a year or less, so this bond must be sold. 1YBF can buy this bond because 1 year maturity is what 1YBF wants.

If 1YBF buys 2YBF’s bond, it will have to pay more money than the principal + coupon that the bond will yield. The price will be set in such a way that 1YBF will get exactly 4% return, as that’s the market rate for a 1-year bond today. This is called mark-to-market pricing.

Interest rate movements and bond returns

From the above description, it might sound like buying longer duration bonds is better than buying shorter duration bonds. But it’s not that simple. Markets don’t give us more money without taking on more risk. In this specific case, 2YBF is taking on interest rate risk. If the market rate for 1 year bonds has gone up to 5% by the time 2YBF sells its 1 year bond, 2YBF will have to sell the bond at a loss.

This is how bond returns correlate with interest rate movements:

• Holding longer maturity bonds is good in a market where the interest rate remains constant or keeps falling. You lock in a higher coupon rate and hold it for a long time.
• In a market where the rate keeps rising, holding shorter maturity bonds is better. You can keep buying fresh bonds at higher and higher coupon rates.
• In a dynamic market where the interest rate fluctuates up and down, you cannot stick to a specific duration. Something like a dynamic bond mutual fund will allow the fund manager to generate alpha by tactically buying and selling. In the scenario where 2YBF had to sell the 1 year bond at a loss, the fund manager may (or may not) choose to hold that bond till maturity to avoid selling at a loss.

Does this mean dynamic bond funds are a good investment?

It’s hard to generalise like that because higher return always means higher risk. I looked at 1 year and 3 year rolling returns of a constant maturity gilt fund (which holds bonds maturing in 10 years) and 2 dynamic maturity gilt funds. While minimum return is attractive for the 10 year gilt fund, average return looks better for the dynamic maturity funds.

These funds are also volatile, and an investor who wants predictable returns would want to stick to nonvolatile funds (usually ones with maturity less than a year) or target maturity funds.

1 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)

3 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)

Career growth and inefficiency

When you start doing something new, you are usually pretty bad at it. Once you figure out how to do it right, you stop being bad. With practice, you’ll become good, and the work will become effortless. If you are rapidly growing to new heights, you won’t be spending a lot of time on such effortless tasks. You’ll keep on moving to newer problems and you will likely find yourself struggling again and again.

Image source: pxfuel.com

It’s counterintuitive, but the faster you grow, the more time you spend being inefficient. If you’re too hard on yourself for being inefficient, your growth won’t be fast. Newer challenges will make you feel bad, and you’ll involuntarily resist growth.

If you want rapid growth, you need to change the way you assess yourself. Avoid thinking “It took me 2 full days to write a short business proposal.” Such a thought causes negativity. Instead, you may think “I have finished writing my first ever business proposal. Until today I was only an engineer, but now I am growing into also becoming a businessperson.” Feed on the positives rather than focusing on the negatives.

You need to consciously derive happiness and pride from the challenges that enable your growth. If you expect yourself to be flawless every time no matter what, your growth will be slow and painful.

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PS: Implicit assumption here is that you can tell good results from bad: either you are capable of assessing it yourself or you have people who will give you reliable feedback. This post is not for people who declare victory too quickly even when the quality of their work is poor.