DYK: Why equity is a must-have asset for wealth creation2 min read . Updated: 10 Aug 2015, 12:27 AM IST
Deciding the allocation to equity will depend on your financial goals
The Employees’ Provident Fund Organisation (EPFO) has started investing in equities from 6 August. This has been a long awaited move and underscores the pension fund body’s belief in equity as a long-term contributor to returns. While the EPFO intends to invest up to 5% of its incremental corpus into equities through exchange-traded funds (ETFs), individual investors need not be this conservative in their equity allocation and can broaden their choice of products.
WHY SHOULD YOU INVEST IN EQUITY?
For long-term wealth creation, equity investment is a must. Fixed income investments, such as fixed deposits, savings certificates and even Public Provident Fund (PPF), give you a fixed return, which can grow your money by 8-9% annually, as per current rates. This kind of return is more suitable for deriving near-term regular income. But if you want to grow your wealth, this is not enough.
Investing in equity, on the other hand, means partaking in the growth of a company. So, over a period of 5-10 years, you can see your money grow alongside the wealth of the basket of companies you have invested in through equities. Equity investments, if held beyond 10 years, have the capability to deliver annualised returns of 12-15%. The key is to stay invested for a long period to get maximum benefit.
For interest earned through fixed income products (other than PPF), you have to pay tax at your income tax rate, whereas equity returns are tax-free after a holding period of one year.
And lastly, if you consider that long-term inflation can be anywhere between 5% and 7%, your investment needs to return at least more than that. Post-tax returns in fixed income will barely cover inflation.
HOW MUCH SHOULD YOU PUT IN EQUITY?
Deciding the allocation to equity will depend on your financial goals. While risk tolerance is important, you should try to understand that in the long run (10 years-plus) equity is not too risky. You’re likely to have at least one long-term goal, which is creating a retirement corpus. For this, a higher allocation should go towards equity.
There is no guarantee that short-term allocation, i.e., for goals 2-3 years away, in equity will work. Equity has shown high degree of uncertainty in 2-3 year periods, posing a risk to your short-term goals.
WHERE SHOULD YOU INVEST?
Invest in stocks either directly or through equity mutual funds. Buy stocks only if you have a reliable adviser or understand a company’s business and financials to visualise its earnings growth.
Equity mutual funds are a better vehicle for retail investors. Here you can leave the stock selection to a fund manager. You have the choice to invest in passive funds such as ETFs, which buy stocks mirroring an index, or in active funds, which rely on the fund manager’s ability to select individual stocks for a portfolio.