Truths of Mutual Fund Investing

While studying for the CFA Level 3 exams, my friend Vinay who is an analyst and a dramatist, suddenly got up, went into the bedroom, set up a podium with a light hanging above it and called me in. He said that for the rest of our lives we have to remember some fundamental truths about investing and hence wanted us to take an oath. And there I was standing on the podium, taking the following oath, in the bedroom of all places…. “The value of any financial assets is the sum of the cash flows generated over its lifetime discounted at an appropriate discount rate”. That’s quite a mouthful isn’t it, let me lay it out for you in simple terms; what this means is illustrated here in the form of three cases.

The basic idea and premise of this article is to let you know that:
1. Stocks are volatile in the short term but might give you a decent return in the long run
2. Fixed deposits and bonds give you static returns irrespective of market conditions
3. For giving you x return there is only a certain level of risk that you should take, no more.
4. You should choose your investment vehicle depending upon your risk appetite and your time horizon of investment.

Read on to know more...

To start; assume risk free interest rates on government bonds to be 8% and then moving up to 10% in one case and moving down to 5% in another case.

Since stocks are more risky than government bonds the return expectations on stocks are higher. I have assumed that the returns expectation on stocks to be 2x the long term interest rates on bonds.

The figures used in the above table are for illustrative purpose only.

In Case A, if there is a chance (not guaranteed) to earn Rs 100 at the end of year 1, then the investor should not pay more than Rs 86.2 in order to earn a return of 16%. The Rupees 100 has been discounted at 16% (Formula: 100/ (1+16%))

If interest rates move up to 10%, then the expectations from stock would be 20% return, and the investor should not pay more than t Rs 83.3 in order to earn a return of 20%. (Formula: 100/ (1+20%))

Similarly if interest rates move down to 5% and now the expectations from stocks is 10%, then the investor should not pay more than Rs 90.9 in order to earn a return of 10%.(Formula: 100/(1+10%))

To reiterate if interest rates move up, the value of stock goes down, and if interest rates move down then the value of the stock goes up.

While the above rule is what the theory states, the actual stock prices may not move in line with the theory- at least in the short term. Such deviations can pose as an opportunity to invest, or as a huge risk, which on careful analysis can be avoided. Thus there could be situations when the interest is up but the price of the financial asset is also up.

Here are a few charts giving the comparison between the 10 year risk free interest rates, and the returns from the Sensex (a proxy to investing in stocks). One is a long term chart since 1998 and the other is a relatively shorter chart from 2012.

In the long term graph 1 the huge decline in long term interest rates since 1998 warranted an increase in stock prices Interest rates moved down from approximately 12 % to 6%.

However, since January 2012 despite the increase in interest rates, the stock market has also moved up. Interest rates moved up from 7% to 8.8% but the stock prices during this period also moved up by 45%.

I just chose these two periods to illustrate the point, but you can see such short term anomalies in different time periods.

The anomaly since 2012 could be attributed to many reasons. Some of the reasons could be:
1. The huge amount of investments by FII (Foreign institutional investors) assuming that the long term growth rates of Indian GDP will be significantly higher in future specifically from the middle of 2013. This could be based on the assumption that the election results will result in a stable government allowing the government to bring in reforms which could lead to higher growth rates.
2. The interest rates in immediate future may decline, as the inflation numbers seems to be softening. This assumption could be gaining ground as the academicians point out that the aggregate demand is so low, that the RBI should concentrate on reducing the interest rates to revive the demand and not worry too much on inflation.

While both the assumptions stated above could be valid, It is possible that events could turn otherwise i.e. GDP growth could still be slow and interest rates may not decline. This means that there is more risk than returns in the immediate future.
The risks could be:
1. The election results could throw up a messy coalition and since this would be unexpected it could result in a sharp decline in stock prices.
2. A sell off by FIIs and exit from India could also impact the currency. A weak currency means expensive bills for oil and thus lower leeway for RBI to reduce interest rates as inflation could still be high.
3. On the ground check with corporate India still suggest a weak environment and therefore earnings growth could be in high single digits as opposed to high double digit growth expectation. A reform agenda by the new government even if it comes through, will take time to translate into actual earning number for corporate India. A lower unexpected earnings growth could translate into lower stock prices.

In addition to the above risks specific to India, the global risks are:
1. The problems in Eastern Europe escalating into a major crisis.
2. The tapering by FED could result in US yields moving up, resulting in some FII reducing their exposure to India.

In conclusion: we have what I call a “GRR” problem, i.e. Growth vs. Risk vs. Return problem.

If everything falls in place as expected, there could be some more returns left in the markets and it could go up a little before it starts to focus on earnings, but if any of the risks play out then the decline in the market could be very sharp.

It appears that there is more risk than return and high growth is still some time away. Cash and Caution is better and it is always good to remember the oath
“The value any financial assets is the sum of the cash flows generated over its lifetime discounted at an appropriate discount rate.”

Above article is authored by Quantum.

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