Building Wealth through Equity

In reaction to my tweets as well as my blogs where I am not exactly fanatic about Systematic Investment Plan, a reader queried me on “How to build Wealth”.

Wealth is described as “an abundance of valuable possessions or money”. While I don’t know who you are, the very fact that you are reading this means that you are comparatively well off. You may not be “filthy rich”, but you are rich enough to understand the nature of things and are interested in improving yourself.

Most advertisements of SIP suggest that by putting your savings into equity (specifically mutual funds), you will end up wealthy. While definitions of wealthy would differ (most of us consider ourselves not wealthy), a UBS survey in 2013 put the definition at $5 million with $1 million in hard cash. In India, that would come to (based on PPP) somewhere near to 10 Crores (8 Crores of Assets, 2 Crores of Cash).

Given that most of the Richie rich figure in the Fortune 500, let’s glance at it to see how they came to acquire such wealth. While Forbes doesn’t list out how much of the wealth was self-generated vs inherited, the top is dominated by persons who started out companies that went onto become mega corporations. Among the guys from Finance, many of them are fund managers who made their riches managing other people’s money.

 Of course, the list is a list of Survivor’s for only those who survived and continue to thrive find a place. For every one of them, you can easily count 10 – 20 who may have come close if not for an error in business / strategy that dragged them down and another 1000 – 10000 who started businesses with similar ideas but went nowhere.

The biggest wealth generation happens if you start an industry and find yourselves incredibly successful. If you start of something and it fails to get traction, you could end up losing what you have. Entrepreneurship is not for everyone and hence while the riches at the end of the line maybe great, let’s accept that is not an option for the vast majority.

Investing in Fixed Deposits / Bonds though have a place in one’s portfolio is unlikely to provide you with strong inflation adjusted returns, forget about building wealth. Insurance is not an investment regardless of how your agent put it. Real Estate was in the last decade a real wealth generator but I believe prices have reached way above their equilibrium making them an asset class that could actually destroy wealth, forget generating it.

Gold has in recent past given good gains though given that there is no value other than maybe the fear that drives its price (other than our own incessant demand), I doubt it could generate wealth though it could protect if a catastrophe were to hit the country. Then again, if a catastrophe of that nature were to hit, the price of Gold would be the least of your worries.

 That leaves us with only one asset class – Equities. As long as the country is growing, firms will grow in line with it providing us growth of the nature that cannot be attained elsewhere. Here is a chart to showcase how great the difference in returns can be

As the chart (from US) clearly shows, equities beat other asset classes by a wide margin and this through 2 World Wars, Vietnam War, the Great Depression among other catastrophes that struck the country through that time.

But investing in equities is not an easy task given that at any point of time, there are more than 2000 stocks that trade on the Indian stock markets. While Direct Equity investing can be an enriching experience, it’s not suitable for everyone given the efforts required to be put in and the understanding required to be able to differentiate between good stocks and bad.

One can avoid this problem by investing with a fund / fund manager of repute. Here again, our options are

1. Mutual Fund
2. Portfolio Management Schemes (PMS)
3. Alternative Investment / Hedge Funds

For most investors, the first carries the biggest appeal since the entry requirements are low. Add to that, tax treatment of profits is the best only for those investing via Mutual Funds.

But once again, we face a problem due to the huge number of funds available for investing. For example, there are (including Index / ETF’s) 80 Large Cap oriented funds. Add Mid / Small / Multi Cap, Debt / Fund of Funds and the list grows to a phenomenal 582 (as of Feb-16) funds.

If selecting stocks to invest was tough, selecting the right fund managers isn’t easy, especially given the fact that even fund managers change firms rather regularly. Most financial advisors take the easy way out and recommend the best performing schemes of the last X years. But when asked the probability of them remaining best performing in the coming X years, they draw a blank.

 Once upon a time, fund managers beat the index handily given the clumsy approach by which indices were built and maintained. Those days are over though as data shows a drastically reducing out-performance by fund managers which comes to our next point.

If fund managers (who are professionals with huge amount of experience and knowledge) cannot beat the market consistently, what other options remain for an ordinary investor who cannot spend the time to learn and invest in the right stocks?

To me (and as investors are finding out in a big way in US), rather than keep jumping through he loops on which fund / fund manager shall work in the coming year, the best way to generate wealth in equities is to invest in the Index itself. While buying and maintaining 50 stocks (Nifty 50) is not easy for anyone, we do have an easy way in terms of Exchange Traded Funds.

Exchange traded funds have the same advantage of Mutual Funds when it comes to tax treatment. Since it’s a single instrument, you will not need to invest into 3 – 5 mutual funds in the hope that the diversification will ensure that one bad fund will not ruin your returns.

Research has shown that a 60::40 allocation to Equity::Debt with say a yearly rebalancing is a combination that is tough to beat by most funds / fund managers. Now that isn’t so tough, is it?

 The biggest advantage is that when either Bonds become over-valued or Equities go into a bubble, your rebalancing will ensure that when the drop comes you aren’t as much affected compared to someone who blindly keeps investing without regard to valuation.

It’s an automatic way to address concerns of buying when markets are expensive and selling when markets are cheap since the rebalancing will ensure you do just the opposite. As stocks fall (and your value of investment in Equities decline), you will shift (at the time of the rebalancing) from bonds to equities thus adding when markets have fallen. And when markets perk up, you do the reverse ensuing that you lock up some of the profits rather than see it wither away when markets turn for the worse.

Of course, despite all this, you will not still build real wealth. Real wealth is built by taking risks and concentrating on absolute returns and not relative returns. But that is a story for another day.