Investment advisors never tire of telling us how it's always a good idea to start early and invest regularly so as not to miss out on the power of compounding. This is particularly true when it comes to selling retirement schemes and SIP investments.
While there is no dispute on starting early and investing regularly, we need to be wary of its use.
Advisors usually show workings on a spreadsheet of how money compounds over time in case of a bank deposit. But it may be misleading to stretch a deposit example to stocks and funds. Undoubtedly, equities and funds have delivered superior returns over the long run when compared to other asset classes, but this may not be only on account of compounding.
Two assumptions
The arithmetic of compounding works on two strong assumptions
(a) periodic cash flows at a contractual rate and
(b) the cash flows re-invested back at the same contractual rate and not consumed.
For a bank deposit that contracts to pay 8 per cent compounded over five years, compounding works because no interest is paid out, but is reinvested back and the same interest rate is applied on the enhanced corpus. In fact, in the case of fixed return investments, such as bonds, there is a third assumption, which is that there are no defaults in payments (credit risk).
But a mutual fund's returns are not by way of cash — they represent unrealised gains arising from the change in NAV over two time periods. For compounding to work, one would need to cash out gains every year and reinvest them back immediately, on the assumption that it is reinvested at the same rate. Clearly, this is not sustainable. It could be argued that mutual funds, by ploughing back their realised surpluses into the fund are working towards growing their NAVs.
Returns must be positive
But the fund returns are neither contractual nor guaranteed, let alone being re-invested at these rates. For compounding to work, fund returns not only need to be positive, but must also be consistent year-on-year. Even a year's negative returns can render the projections awry.
Among market instruments, theoretically, only a zero-coupon bond delivers a realised return that equals its priced yield to maturity. This is the same argument that is held against concepts such as the IRR (which relies on the principle of compounding) in interpreting financial projections. One needs to be cautious about relying on the numbers to plan one's future. The regulator's statutory warning about past returns being a proxy for the future should be borne in mind.
Top 10 Tax Saving Mutual Funds to invest in India for 2016
Best 10 ELSS Mutual Funds in india for 2016
1. BNP Paribas Long Term Equity Fund
2. Axis Tax Saver Fund
3. Franklin India TaxShield
4. ICICI Prudential Long Term Equity Fund
5. IDFC Tax Advantage (ELSS) Fund
6. Birla Sun Life Tax Relief 96
7. DSP BlackRock Tax Saver Fund
8. Reliance Tax Saver (ELSS) Fund
9. Religare Tax Plan
10. Birla Sun Life Tax Plan
Invest in Best Performing 2016 Tax Saver Mutual Funds Online
For further information contact Prajna Capital on 94 8300 8300 by leaving a missed call
---------------------------------------------
Leave your comment with mail ID and we will answer them
OR
You can write to us at
PrajnaCapital [at] Gmail [dot] Com
OR
Leave a missed Call on 94 8300 8300
-----------------------------------------------
