Every investor wants to create huge wealth by taking the best investment decisions. But sometimes decisions taken to create wealth become responsible for the destruction of wealth itself. Generally, investors are unaware of the Break-even rate of return which is a minimum return to catch up with inflation and meet our tax responsibilities. At a break-even rate of return, an investor is neither creating nor destroying his wealth. Any return above break-even return is the net return that is going to create wealth for an investor.
What is Investment?
Investing is forgoing some money today to get more money tomorrow. Forgoing money means converting money in some other asset that is going to be valuable in the future. There are a number of asset classes in which money can be invested:-
- The investment could be made in financial instruments like fixed deposits in banks and corporate or debt instruments like bonds and debentures. These investments are generally made to get a periodic return in the form of interest and original capital is returned on maturity. A large portion of the return earned on these instruments is eaten by inflation.
- Wealth Creation is also possible with Investment in Precious metal Like Gold, Silver, which has appreciated sharply in past. But this investment does not provide any periodic return.
- Real estate is also an attractive asset class for wealth creation. But this requires not only a large amount of capital but also specialized knowledge about property business.
- Another widely used month of wealth creation is through investment in Equities in Stock Market. In this category, the Investor has the option to choose between periodic return and growth. In the Stock market, periodic return is in the form of dividend which is exempt from income tax u/s 10(34) of the Income Tax Act. However Investments in this category are subject to market risk, Hence investor must consult their financial advisor before investing. Investors can choose to invest directly in Equities or in units of Mutual Funds. There are two methods of wealth creation under this category ‘Trading and Investing” (This is further explained in Heading ‘Trading Vs. Investing“)
Investors should not invest their hard-earned money without understanding risk and return of proposals.
Now the question arises which assets should we choose for investment? There is no direct answer to this question because each type of investment has some advantages and some disadvantages. It depends on the needs and situation of an investor and which asset class is suitable for him. Investors must consult their financial advisor before investing.
Relation between inflation and interest rates:
- Interest rate is the rate at which interest is charged by the lender to a borrower for using the money for a given period of time. For example interest rate on FD is 7% p.a. Government may control the interest rate in the market by changing monetary policy.
- The inflation rate is the rate of increase in the price of goods and services over a period of time in an economy. The inflation rate is controlled by the demand and supply of goods and services in the market. When the demand for goods & Services increases without much increase in supply then Prices will go up. When the demand for goods & services decreases without a cut in supply then Price will decrease. On the basis of prevailing market conditions, Government tries to balance the inflation rate by bringing changes in the interest rate and monetary policy.
The relation between interest rate and inflation can be understood by analysing the impact of change in the interest rate on inflation. If the interest rate on consumer loans is changed, how inflation will react:-
- If interest rates are decreased then money/loans will be available at an easy rate to the public. An increase in borrowing will increase the money available to spend with consumers. If more money is available to spend then demand will rise without much increase in supply. An increase in demand over supply will result in an increase in prices and the Inflation rate will be higher.
- If interest rates are increased, it will make people cautious to borrow less and save more. Due to this, demand will decrease without any cut in supply. This will result in sustaining or reduction in prices. Hence inflation rate will be lesser.
Hence the relation between the Interest rate of consumer loans and Inflation is negative. However, inflation has a positive relationship with the interest rate on producer loans. Hence inflation rate may be controlled by bringing change in demand & supply through a change in monetary policy.
History of changes in repo rate
The chart given below shows the history of changes in repo rate by RBI to control inflation and to achieve the objectives of monetary policy:-
Inflation and Rate of Return
The rate of Return on your Investment is very closely linked with inflation. It is very important to understand the impact of Inflation on the rate of return on investment. Generally, if the interest rate on FDR is 7% then the investor is of the view that the rate of return on FDR is 7%, Which is a misconception, We should understand the clear meaning of return, actually return is that percentage by which purchasing power of an investor is actually increased. We can understand this concept with the help of the following example:-
Assume you invest Rs. 100000/- in an FDR on an interest rate of 7%. Then you earn Rs. 7000 in one year as interest. Now assume an inflation rate of 5% (it means the price of consumer goods has increased by 5% during the year). Due to inflation, now we have to pay Rs. 105000/- for the goods which were available at Rs. 100000/- one year before. So net increase in purchasing power is only Rs. 2000/- (107000-105000). Now assume you are in 20% tax bracket then you have to pay 20% of the interest amount Rs. 7000 /- as income tax. The tax burden on interest amount comes to Rs. 1400/- (20% of 7000). Hence now the net increase in your purchasing power is Rs. 600/-(2000-1400). Hence the rate of return of your investment in FDR is 0.6% only.
In short, if your money increases @ 7% and inflation are 5% then the net increase in your wealth is only 2% before considering income tax. Now it is worth mentioning that income tax is chargeable on your earnings without adjustment of inflation. Hence if the tax rate is 20% then 20% of 7 i.e. 1.40% of your investment is paid to the government as tax. Hence the Net rate of return which is available to increase your wealth is only 2% – 1.40% =0.6%.
What is the Break-even Rate of Return?
The Break-even rate of return is the rate at which an investor neither creates nor destroys his wealth. If an investor is earning a return that is below the break-even rate of return, then he is actually destroying his wealth. Any return above the break-even rate is the only addition in the wealth of an investor. The Break-even rate of return is the minimum rate of return that is necessary to earn to catch up with inflation and tax liability.
Before decision on an investment proposal, find out your break-even rate of return. For example-
If the inflation rate is 7% and the tax rate applicable to Mr. X in respect of the Investment Proposal is 30% then find out the break-even rate of return for Mr. X.
Break even rate of return = Inflation rate / (100-tax rate)%
= 7 / (100-30)% = 7/70% = 10%
Hence If Mr. X gets 10% then he will be at break-even because the increase in prices is 7% and the tax payable is 3%(30% of 10). If Mr. X gets any return of more than 10% then it will add to his wealth of Mr. X.
Is inflation good or bad?
Inflation is not always bad. For healthy economic conditions, inflation is a must. Take the example of an economy with nil or a negative inflation rate. It means prices are not increasing at all or prices are reducing. It further means that demand is decreasing in the economy. Then there will be no reason to set up new factories for production if there is no demand. There will not be any industrial growth which is a very bad sign for the economy.
If there is inflation, it means demand is higher than supply, and demand is increasing and supply is also required to be increased to meet the demand. This situation motivates to set up of new plants, factories, or industries to increase the supply. Hence Inflation is the reason behind industrial growth.
Trading Vs. Investing
There are two methods of creating wealth through the Stock market, Trading & Investing. Trading is basically purchasing a share at a low price and selling it at a high price without considering the industry, company or fundamentals of companies. The movement of price is the only criteria for the purchase and sale of shares. The decision to purchase or sale of a share is generally taken on the basis of the movement of the share on a technical chart. Trading could be intraday or holding over the next few days, weeks, or months. Thus by rotating their wealth many times in different shares, traders try to book as much profit as they can. Generally, Trader has very limited capital, which is used as a margin for high-value trading. This way of wealth creation is very risky. Profits of trading activities are taxable under the head “Profits and Gains of Business & Profession”.
Investing is the other way of wealth creation through the stock market. An investor does research about the fundamentals of the company, industry, and risk associated with it, before investing in any stock. He does not react to short-term movement or price. A technical chart is not for Investors as an Investor is not intended to withdraw money on the short-term movement of price. Investors generally keep their money invested for long period. Short-term capital gain is taxable at @15% and long-term capital gain above Rs. 1 lac is made taxable at @10% in Finance Budget 2018.
Ground Rules of Investing
Every investor tries to build huge wealth through investing but many fail. There are many mistakes that investors make unknowingly which lead to wealth destruction. There are some ground rules which may help in the creation of wealth through investing:-
- Concentrating on a business that is easily understood by investors, will make it easy for the investor to understand favourable and unfavourable conditions for the business and risk associated with it.
- Look at the business where you can see the future for at least ten years.
- After selection of business, look for a company within the selected industry that has management caliber, competitive advantages, and potential to grow at above industry growth rate. Search about management depth, integrity, ability to adapt the change and the way it treats its employees, suppliers, and customers.
- Develop a methodology for stock selection and stick to it.
- Work hard in research before entering into a position because profit is simply the difference between entry price and exit price. While exit price is in the control of various factors affecting it, the entry price is fully under the control of an investor. If a share is selected on the basis of fundamentals, a temporary fall in price should not affect your decision.
- Study at least three years of financial results.
- Study fundamentals like PE Ratio, EPS, Return on Capital Employed, Return on Equity, Growth rate of earning, Price book ratio, etc.
- There are many pricing models for shares like the Dividend pricing model, earning pricing model, etc. Choose the appropriate model and calculate the fair price of the share.
- Look for consistent performance because one year’s performance could be accidental or managed.
- Buying a good stock is not enough, Review your portfolio on a periodic basis and take necessary steps if the fundamental alert is there.
- Analyse the average rate of return provided by share over a period of time but remember past performance is not a guarantee for future performance.
(Investments in stock markets are subject to market risk, Investor should consult their financial adviser before investing)
Happy Investing