Compounding | Portfolio Yoga

Save Early or Lose Substantially?

An often repeated mantra is that if you don’t start saving early, you end up losing tremendously. You cannot argue with a statement like that , especially when it’s backed by evidence of the difference in returns if you start at 20 or start at 30.

Keeping in mind my skepticism with much of what goes around as “gyan”, I made this kind of sarcastic tweet in reply to one such tweet. Now, just to be clear, I hold Dinesh in high regard for his understanding of Finance and while I did use his tweet as material to push my agenda, it has nothing to do with him perse.

https://twitter.com/Prashanth_Krish/status/1327548992037609472

Kids in the US are burdened by Education Loans they take. The burden is so heavy for some that they would need to keep paying off till retirement. So, why do they even bother? The reason is simple – higher the education, more the remuneration and lower the possibility of being unemployed

https://twitter.com/Prashanth_Krish/status/1327624954192412672

One would rather be employed and paying off debt than unemployed with no debt but no optimism about the future either. While I don’t think that education in itself is everything, it’s a foundation that can help a lot.

Let’s go back to the original tweet. What is seen is the difference in outcomes based on a straight line approach to savings. If you start saving at 20, you are way better off than someone who starts to save at 30 assuming both end at 60. This is not surprising and it’s not just about compounding effects. Person A is saving for 40 years versus Person B who is saving for 30 years. 10 years of savings and the compounding does matter as the chart below shows

There is a very big hidden assumption here. Not only is Person B starting at 30 which is 10 years later than Person A but he is investing the same starting capital. What if rather than invest 10K per month, he is able to invest more?

When he is 30, Person A is investing roughly 16,300 per month (10,000 per month with an increment of 5% per year). If Person B starts his year 30 by investing 31,800 per month (close to double what Person A is investing) which too increments by 5% per year, this is what the chart looks like

Basically, by starting with a higher number, Person B despite starting late is able to catch up to Person A.

But he is investing more, you complain. This is true. My assumption is of course that he has not whiled away his time between the age of 20 to 30 but gathered either diverse experience which helps him earn more or got himself a higher degree which provides a higher salary and hence even with a similar savings rate is able to save on an absolute terms a higher number.

But lets equalize it in a different way – let’s assume that both work for the same period of time – 30 Years. Person A hence retires at 50 while Person B retires at 60. When Person B starts to invest, we assume he will invest the same amount per month that Person A is investing at that point of time and increment 5% per year. Where will they be when they hit 60 years of age?

We are back at Point 1 though slightly better. Person B trails Person A by nearly 50% even though Person A has retired a good 10 years earlier.

But there is another assumption we are overlooking. We are assuming that both of them get similar returns. How much of a higher return should Person B get to catch up with Person A at the age of 60?

The answer to that is 15%. If Person B can get 15% per Annum vs 12% per Annum for Person A, at 60, both of them end with a similar capital.

Here is the interesting thing. Both Person A and Person B can expect 15% from Equities and still end up at the same outcome at the end. The difference though would come from Asset Allocation.

While Person A can have a 60 / 40 Asset Allocation in favor of Equities and reach the number as Person B who is forced to have 100% in Equities. In other words, though both have similar return expectations from Equity, the allocation they need to take will be different.

For Person B to have the same outcome as Person A with the same Asset Allocation, he will need to generate 20.3% from Equities – something that very few have been able to achieve in the long run.

On the other hand, Costs can play a large role in the final outcome. Assume both invest in Large Cap Equity but Person A invests through a Mutual Fund Distributor in a Active Large Cap Fund whereas Person Invests in a Large Cap Index Fund / ETF.

While both of them will hold a similar portfolio {minimum of 80% matching}, Person A is paying a 2% fee vs Person B who will end up paying 0.10%. That is a straight forward gain of 1.90% and actually reduces the requirement for Person B to outperform Person A by that much. To get 15% returns in Equity after fees, Person A has to have a fund that delivers 17% vs Index fund Returns of 15.10%. If you have looked at SPIVA data recently, you shall notice that most Large Cap have it hard beating the Index let alone by that margin on a long term.

When we were young, we were taught the concept and Importance of Savings by stories such as the Ant and the Grasshopper. I don’t think we should deny the importance of a disciplined saving from an early age. But is everything lost because you started late though the barriers are higher.

While I do like the message of saving early being good there is nothing to be scared about if you started out late. Finally, it’s not the amount you have at 60 that really matters as much as the quality of life you have lived. The very fact that you are reading this puts you into the 10% of the population and one that is most likely to succeed as well.

Want to Stress Test your Retirement – check out the simple calculator(s) here. Of course, the assumptions build in here are US related, but should give you a chart of how other paths than the one excel plots.

The Impact of Fees on long term Returns

In the days of the old when Stock Broking was carried out in a ring with people shouting at one another, brokerage as a percentage made eminent sense. Buying 100 shares was far easier than buying 10,000 shares for example. A percentage fee made sense since a higher effort was required to buy such huge quantities while at the same time trying to get it for the best possible price for the client.

Once we moved to computerized mode and we did that once NSE came into existence, this should have gone out of favor but it did not. In fact, one of the reasons I became a broker was the attractiveness of the fees. Placing an order for say 100 shares in the new environment took me as much effort as it was for placing an order for 1000 shares but the magnitude to the income was 10x, 100x if you consider a client who wanted to buy 10,000 shares.

Once online brokerages came into being, this should have vanished since now the client himself did all the work and the broker had nothing to contribute regardless of the size of the order and yet it did not. It took Zerodha to shake things up starting in 2010 but even today, that is not the norm.

In the world of investing though, it’s been a percentage fee all the time even though the effort to manage your money of say 10,000 isn’t very different from the effort to manage another person’s investment of 1,00,000. Higher the investment, the more the fee you end up paying in absolute terms even though there is no real difference in the way you are handled vs the smaller guy.

While we have order based brokerage and flat fee advisory, we are yet to come across any fund that charges a fixed fee and why should they anyway. The barrier to entry is high and one that ensures not every Jill can become a fund manager and even if he does, unless he can showcase good performance over a long time, money ain’t going to flow and the high cost structure makes it a non-feasible venture right at the start.

When the mobile revolution started in India, one needed to pay approximately 24 rupees per minute for every incoming and outgoing call. This fell as competition rose and the number of subscribers grew. Today, we are accustomed to pretty much free outgoing and incoming once you have paid a fixed fee.

What the Cable guys used to charge and continue to charge as is the case with say a DTH operator or OTT networks like Amazon Prime or Netflix charge is based not upon how much you use or not use but based simply upon a fixed fee. I may watch them on a 21 inch television or project them on a large screen, watch them for an hour once in a way or watch them continuously for days – the fee is the same.

A few Portfolio Management Service companies offer a zero management fee but charge a percentage on performance. On the face of it, this seems ideal – I make money only if you make money. His fee structure was simple – Zero Management Fee, a 6% hurdle rate and 25% of the profits above it.

This has been copied by many others though with one unique distinction. Most of them aren’t Warren Buffett. In the years he managed the partnership’s, he had not one negative year. This even in years when the S&P 500 had a negative year. In 1966 for example, the Dow closed with a loss of 15.6% while Buffett generated a positive return of 20.4% for his clients. How many such fund managers are around these days anyway.

To encourage equity investing, talking heads regularly talk about how the long term returns for the Indian market is 15% never mind the fact that Sensex was not even there let alone investable during the star period. But overall, the assumption is that you should get around 12% for the investments you make in equity.

The question is not whether you need to pay a fee and given that we don’t really have a choice in terms of Fee only Investment Products vs % fee based Investment Product, such a question adds no value either. But it’s about whether you are getting value for the fee you pay. If a fund performed in line with the markets, should you pay 0.05% or 2%. Depending on your investment capital, this can run into lakhs of Rupees – not something that should be taken lightly or ignored.

A very well known fund manager recently posted his long term track record of 15 years and it’s impressive. If you had invested say a Crore of Rupees with him when he started, the value of the said investment today would have been before fees worth nearly 14.40 Crore. Post a small 2.5% fee levied year after year, this drops to just below 10 Crores. A 30% cut in the profits.

The returns are still better than if you had invested in Nifty 50 (Total Returns) , so maybe this is okay or is it. As an investor today, you have no clue as does the manager whether he will provide you with an Alpha say 10 or 20 years away while the only guarantee is the fee you pay.

Much of the personal finance space about savings is dedicated to saving on small things that bring joy to our lives but would barely make a dent when it comes to the long term. There are plenty of stories of how instead of buying a Royal Enfield bike you had invested the same in the stock, you could have afforded a Merc maybe. Of course, most of them don’t use LML Vespa (a fairly nice scooter back in the days as an example) since if you had invested in the shares of LML instead of buying that scooter, your value of the investment today would have been Zero.

From a personal point of view, I think it’s important to save where we can and spend where we must.

So, why do we pay. Are investors really that ignorant about the impact of fees on their final returns?

The reason we pay is not because we are generous but because we expect better returns than the market. In a world or market where data cannot be gathered, this could hold true – we don’t know what we don’t know.

But we are in an interconnected world and data to back the fact that not only does fees eat deeply into long term returns is out there but we have sufficient data to show that very few fund managers after accounting for survival bias are even able to beat their benchmarks.

So, why do we pay? Is it Greed or is there something else. Why do funds that have massively under-performed their benchmarks continue to get new investors to bet that the “Worst may finally be over”. Is it Behavioral?

Our Goals are 20 / 30 years out and fees we pay can have an extra ordinary impact on the final capital we aim to reach but one that is less discussed and even lesser talked about.

One reason passive indexing is picking up so much is not only because they are cheap but also because most funds don’t really provide a differentiation that makes the fee worth paying. A fund that is a closet index has no reason to charge anything more than what a passive fund should and yet most closet funds (and the number of such funds will only go up in time) are happy to charge for the Beta while ignoring the impact it has on the Alpha.

As I finished writing this, I stumbled upon this

https://www.bloomberg.com/opinion/articles/2015-04-30/how-fund-managers-take-a-yearly-cut-of-your-savings

and a even better counter opinion

Why do Investment Firms Charge AUM Fees?

Final Thoughts

Writing for me is a way to clear my own thoughts and if it can help someone else, so much the better. As a trader, we once upon a time used to complain that if not for the brokerage we would have been profitable. I should have become profitable once I became a broker myself for there was no brokerage and yet, magic did not happen. It took me a long time to realize the mistakes and rectify the errors so as to speak. So, apologies if this post comes up as a confused one this is not about providing the right answers but trying to ask the right questions.

Expectations, Probability and Reality. Can you really make 100 Crore by Investing 10 Lakh

Most kids coming home from their exams don’t expect anything less than a First Class. Parents don’t expect anything less than their ward getting into the IIT’s of the world. Investors assume that they can easily generate returns that would put even Warren Buffet at his prime to shame.

On Twitter, experts for most of the time seem to showcase how great their stock selection / trade selection was – look at how the stock bounced right off the support. Fundamental biased investors generally are eager to show how easy it was to know that the stock was a fraud, post the event even though when the stock was actually doing far better than the market, there are few sane voices questioning the same with data.

When the market was running up in the years prior to 2018, Mutual Fund managers were more than happy to show how great investing is. Now that the Large Cap Index in itself is still doing good but stocks have crashed, the excuse is that it’s “darkest before dawn”.

The reason investors aren’t able to stay the course is not because they are greedy or lack discipline but because they were misled on the expectation of the returns they could achieve for the risk they took.

Thousands of home buyers today have either paid or still paying for houses that may never be delivered. They weren’t greedy other than being dreamy about owning their own house – they were misled when it came to the risk they took when they signed on the dotted lines.

On the very long term, markets have gone up and hence if you keep investing, you will do well is the mantra of every analyst in town.

Take a look at the chart below – this chart is the Total Return Index of S&P 500 since 1871. The growth is just amazing with hardly any drops.

But the reality wasn’t so easy queasy. Can you see the small dip during the early 1930’s? Well, that was what is today known as the great depression. A famous pic from those times

By the time, the low was made, the Dow was down a preposterous 89% from its peak. US hadn’t seen a crash of that magnitude before or later. Yet, the Index recovered and those fortuitous to be holding on to the survivors would have made it back. But do we really expect ourselves to survive such a carnage without a change in the way we invest?

While the Bombay Stock Exchange is the oldest stock exchange in Asia, we don’t have data on stock prices of historical years. Sensex which is the bell weather index came into life only in 1986. Since 1986 to today, the Compounded Growth rate has been 13.50%.

To make that 13.50%, you should have been able to participate in the Sensex for the last 32 years and going through long periods of negative return. In other words, you would have been required to be a Saint. Of course, all this is theory since there was no easy way to participate in the Senex other than to construct the same on your own in the same weights. The first index fund came into life only in July 1999.

Acclaimed Guru and Stock market expert, Ramesh Damani recently gave a talk with the clickbait topic

“How to make 100 crore by investing 10 lakh: Ramesh Damani”

He talks about the huge advantage of starting to invest early and has the following side

Staring to save early is good but does that really provide the edge. There are two things worth noticing in the slide – One, the period of Savings and two, the small number at the last which says “Interest Compounds at 15%”.

Sensex has compounded at 13.50% and since this doesn’t include Dividend Yields which can come to 1%, 15% seems pretty much achievable. But does the static convey the real picture?

While I don’t have data on Sensex PE in 1986, in January of 1991, Sensex was trading at trailing four quarter price earnings ratio just below 10. We have seen this low a number only once post 1991 and this was in 1998. Neither the crash of 2000 nor the crash of 2008 brought down the market to such a cheap level.

Ramesh seems to have taken the 15% number from Sensex of the past 30 years. But the larger question is whether the last 30 years is representative of the next 30. No one knows how the next 30 – assuming you are saving for your retirement will generate.

But was Karishma really able to out-perform Kareena? Lets run it through real Sensex numbers to see how they performed. Remember, Karishma saves for just 7 years while Kareena saves for 27 years. If both invested in debt yielding 15% CAGR, this holds true – but markets don’t give out 15% or even 13.50% returns year on year.

Since we have only 33 years of clean data, lets give Karishma the first 7 years (1986 to 1992). For Kareena, we shall start investing in 1992 and invest till 2017. So, how do they fare by end of 2018?

Karishma has invested 50 thousand for 7 years which is equal to 3.5 Lakhs. This is now worth a fabulous 1.58 Crores – in other words, her investment has generated a XIRR return of 14%.

Kareena started off in 1993 and invested until 2017 for total investment of 12.50 Lakhs. Her current value is a mere 70.50 Lakhs. XIRR comes to 11.50%.

So, what happened. How did Kareena beat Karishma even though she invested for a longer period and through multiple bull and bear markets? Is this all the magic of Compounding?

The reason is simple – from when Karishma started to invest till date, index had a CAGR growth of 14.13%, for Kareena this number comes to 10%. In other words, much of the difference can be accounted by the timing.

Karishma started to invest when Sensex was around 500 levels and ended her investment when Sensex was around 2500. For Kareena, the start point was at 3350 and ending at 34,000.

Since both of them investe in the same instrument, we can get a better understanding by looking at how many Sensex units Karishma got for her 7 years of investment and how many years it took Kareena to accumulate the same.

Karishma over the seven years accumulated 440 Sensex units (Investment divided by Sensex). Kareena was able to accumulate just 195 Sensex units over her entire investment.

It’s similar to someone investing 50 thousand in Eicher Motors when it was a small cap stock versus investing 50 thousand when Eicher became a large cap. Return generated by the early investor is tough to match. As the adage goes, the early bird get the worm.

Personal Finance blogger, M. Pattabiraman had a very interesting video where he showcases how timing can influence returns for SIP’s.

Mutual Fund SIPs will not work without luck!!

Given what we now know and understand, what then should one have expectation of returns. Let’s assume if you were to invest a sum of money with a horizon of 10 years, what expectation you should have at the end of 10 years.

A lot depends on where you invest, but for simplicity sake let’s assume that you invest in a large cap fund that shall mirror Index returns.

Lets start with a much smaller time frame than 35 years – 10 years is seen as Long Term and if we can get things right in this time frame, we may as well have a chance to get things right on the longer time frames as well.

For this analysis, I shall use Nifty 50 weekly data which starts in mid 1990. Using weekly gives me more data points than monthly and hence better granularity. What is the range of returns we have seen for a period of 10 years?

The answer is that it can range between a negative 1.60% to a positive 20.28% with average return being 11.65%. That range of returns is just too wide to use it for figuring out how much can we get for our investment ‘n’ years later.

Here is a chart that plots the data (n = 959).

How to read the chart?

The chart showcases the percentage of weeks where investment would have yielded the returns as shown in the Horizontal (x-axis). To get a better measure, you can simply cumulate to the bar you think is the return you need and subtract the same from 1. This is your probability of getting such a return.

So, the probability your return is greater than -1.58% will be 99.69%, the probability that your return would be somewhere near 20% is 0.52%. If you were to take a view of a coin toss, the 50^th percentile so as to speak will lie at around 13%.

While just blindly investing in a growing market will at some point of time provide you with strong positive returns, the inability to project the same can hamper our ability to stay the course. When we are hit with draw-downs, the last thing we calculate is that if the current return is well within the overall bell-curve of returns possible.

Assuming that 6% is the minimum returns we wish to generate from equity, what were the historically bad years to start a 10 year investment in Nifty 50?

We had 156 weeks where investing would have yielded a return of less than 6% after 10 years. The worst years to invest were 1994 followed by 1993 and 1992. Compared to this, 2007 / 08 which too makes a presence was a walk in the park. Investing in almost any day of 1994 and greater than 80% of the days of 1992 and 1993 would have generated returns below 6%.

Comparatively, just 7 weeks of 2007 (bunched around November and December) and 2 weeks of January (first couple of weeks) were the worst weeks.

As much as we think we know the future, it’s one thing to know and quite another thing to live through the same. Draw-downs take a toll not just in terms of money lost (notional or not) but also has a massive impact on our confidence.

The great Stephen Hawking was diagnosed with ALS when he was 21. This being a non-curative disease, Doctors at that time gave him a life expectancy of 2 years. He lived for 53 years more.

In an interview to New York Times magazine in 2004 he said

“My expectations were reduced to zero when I was 21. Everything since then has been a bonus.”

From Warren Buffett to Rakesh Jhunhunwala to Ramesh Damani, I doubt anyone invested with intention of using the proceeds at the end of ‘n’ year for specific purposes. Having zero expectations from your investment in markets can be tough, but if you were to accept that, the task of becoming a better investor becomes easier for nothing the market throws at you will impact you negatively.

Share this:

Share this:

How to read the chart?

Share this: