5 investment lessons to maximize returns; here is all you need to know
June, 08th 2018
When we talk of maximizing returns, we always talk of maximizing returns for a given level of risk or volatility. Let us look at 5 such lessons to maximize returns in investment.
You invest to maximize returns for a given level of risk. Hence returns can never be seen in isolation, but should always be measured with reference to the risk involved. A return of 14% is great when earned with 12% volatility, but a return of 16% may not be too desirable if it is earned with 30% volatility. When we talk of maximizing returns we always talk of maximizing returns for a given level of risk or volatility. Let us look at five such lessons to maximize returns on investment:
1. Start early and stay invested for the long term
When it comes to your portfolio, it is time that matters more than timing for maximizing returns. Portfolio returns maximization is more about time working in your favour. In fact, you will be surprised how you can multiply your wealth tremendously by starting early and maintaining the discipline of staying invested. Let us take two separate cases of a lump-sum investment and a systematic investment and see how it compounds with a longer time-frame.
You invest Rs 5,00,000 at 14% per annum CAGR for different time-frames
In the above table, the investor is doubling his money every 5 years by just keeping his original corpus invested at a yield of 14%.
The incremental wealth ratio starts moving up rapidly as you hold on to your wealth creating portfolio for a longer period. The basic rule of maximizing returns is, therefore, to start early and stick to a quality portfolio. The power of compounding will work in your favour.
2. Always measure returns in risk-adjusted terms
One of the basic principles of investments is that your returns are always commensurate to the risk that you are willing to take on. You need to understand a very important distinction here. Higher returns entail higher risk, but then taking on higher risk does not assure you of higher returns. So, don’t expect higher returns just because you keep on taking higher risk. That is where calibrated risk taking comes into the picture. That means you should only take as much risk as can be justified by incremental returns.
When we measure returns, there are three approaches. The first approach to returns is the absolute point-to-point returns. A return of 18% per annum can be good and 14% average, but there is only so much that you can glean from this. That brings us to the second measure of returns; that are benchmarked returns. Here returns are benchmarked either to the peer group or to the representative index like the Nifty or the Sensex. This is a better measure, but still it does not factor risk. That is where the third measure of risk-adjusted returns comes in. Measures like Sharpe and Treynor can help you measure how much returns the fund manager is generating without adding to your risk. Your aim must be to maximize your risk-adjusted returns on your investments.
3. Stick to rules on asset allocation and rebalancing
One of the best ways to maximize your returns in your personal financial plan is to adopt a structured approach to asset allocation and to portfolio rebalancing. Your long-term goals need a greater share of equity, your medium term need a combination of equity and debt, and your near-term goals a greater share of liquidity. That is how asset allocation can help you maximize your returns. The second aspect is rebalancing. When you set rules for rebalancing your portfolio mix, it ensures two things. Firstly, it ensures that profits are automatically taken out when certain investments outperform. Secondly, you maintain the level of risk as per your profile.
4. If it is long term, it has to be equities
That is the golden rule of financial planning and investment. If you are talking of long-term goals like retirement and planning for your child’s education, then your biggest allocation must be to equities. When it comes to your long-term goals, the biggest risk is not taking on any risk. Equities may be unpredictable in the short term, but over a longer time frame of 8-10 years, they invariably outperform all other asset classes. When you are invested in equities for the long term, the power of compounding really works in your favour and the money works much harder for you!
5. Ultimately, it boils down to effective post-tax returns
The biggest take-away from this discussion is that all returns must be looked at in terms of post-tax returns and not post tax returns. That is what you will realize and that is what matters. Take the case of your long-term equity funds held by you. Till the last financial year 2017-18, long-term capital gains were tax-free. But from the fiscal year 2018-19 onwards, LTCG will be taxed at 10% above Rs100,000. Also, this tax is imposed without any indexation benefits. From your goals point of view, you have to either increase your monthly allocation or you need to reduce your target amount. Compared to equity funds, debt funds are treated less favourably when it comes to dividends and capital gains. However, debt funds score over bank FDs since the LTCG on debt funds is charged at 20% after indexation while the bank FD will entail tax as per the tax slab on the interest earned. That is why tax impact needs to be factored in when you are looking to maximize returns.