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Photo: iStock

Are returns from zero-risk portfolios really risk-free?

Most low-risk products don’t give positive returns after factoring in inflation and tax

In the last one year, the Nifty touched an all-time high of 12,430.50 points, but after covid-19 was declared a pandemic by the Word Health Organization (WHO), it came tumbling down to 7,511.10, losing almost 40%. However, within a couple of weeks, it again surged to 9,000-plus points, an increase of more than 20% from its low. Given the high volatility in the equity market, even seasoned investors have become cautious. Many people are rushing to safety and considering investments in low-risk and fixed-income products to build a “zero-risk portfolio". But does such a thing exist?

LOWER RISK...

Conservative investors, typically, prefer investing in low-risk instruments that pay predictable or fixed returns. Since the risk is lower, the interest rate or dividends you get are usually lower as well.

Different fixed-income products have different features such as interest rates, lock-in periods, maturity, taxability, eligibility and so on. Pick products depending on what’s suitable for you.

For instance, if you are a salaried employee, the Employees’ Provident Fund (EPF), which currently offers the best rate (8.5% per annum for FY20), will be a default product for you. The interest rate for EPF is announced annually. You are mandatorily required to contribute 12% of your salary (basic and dearness allowance) in EPF, while employers are required to contribute an equal amount to the account. You can invest up to 100% of your salary in EPF, but the employer’s contribution remains the same.

If you are just starting out in your job and are looking for long-term investments, the second-best option to consider is Public Provident Fund (PPF), which currently offers a tax- free return of 7.1% per year; the rates get revised every quarter. PPF comes with a long lock-in of 15 years, so it may work for young investors who may not need regular payouts, but it may be unviable for retired individuals not having an existing PPF account.

Some small savings schemes, which give fixed returns, are meant for specific categories of investors. For instance, Senior Citizens Saving Scheme (SCSS) is meant only for senior citizens, while Sukanya Samriddhi Account (SSA) is available for those with girl children.

Since most fixed-income instruments have a lock-in or maturity period, ensure that the product you choose will mature according to the timeline of your goals.

...EATS INTO RETURNS

One of the biggest risks that such a portfolio carries is that of earning negative real returns because the returns that you see upfront are reduced drastically when income tax and inflation are factored in.

Fixed-income products became popular a couple of decades ago when their returns were in double digits. The bite that tax and inflation took out of these returns didn’t bother investors at the time. But most of these instruments offer much lower returns now, which is why it may be too costly to ignore their effects (See graph).

Graphic: Santosh Sharma/Mint
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Graphic: Santosh Sharma/Mint

Simply put, inflation is the increase in prices over a period of time. This basically reduces the purchasing power of your corpus. “Funds allocated to bank FDs and government bonds like RBI bonds, keep losing purchasing power over the years. If your post-tax FD return is 4.5% and your lifestyle inflation is 8%, then you lose 3.5% of purchasing power on 100 each year. At the end of five years, 100 will be able to buy only lifestyle worth 85. In 10 years, 100 will be worth only 71," said Varun Girilal, executive director, Mitraz Financial services Pvt. Ltd, a financial planning firm. Your investments need to be in line with inflation.

A component that is more visible and immediate than inflation is income tax. For instance, if you invest in SCSS, which gives a return of 7.4% per annum at present, and you are in the highest tax bracket of 31.2%, your net return after factoring in tax would come down to 5.09%. However, you can claim an exemption of up to 50,000 under Section 80TTB against interest earned from SCSS.

The best case scenario is when real returns are positive after taking into account inflation and tax. If the real returns are negative, it shows that your savings and investments are shrinking instead of growing.

WHAT YOU SHOULD DO

Though a lot of people prefer to take minimal or no risk on their investments, everyone cannot afford to invest everything in debt products. This is because the low returns will work against future goals. Therefore, choosing the right instruments at the right age and diversifying your investments are two important factors. “There is a big risk in not taking any risk—which is losing your purchasing power over time. The key is to have a risk management plan through proper diversification and systematic planning," said Girilal. Rather than trying to avoid risk, a better option would be to build a plan and allocate one’s investments so that you can endure and ride through risk and volatility, he added.

How much the equity-debt proportion should be depends on the duration of the investment and your risk appetite. Ideally, you should take a larger exposure to equity at a younger age and scale it down as you grow older. When you are younger, goals such as retirement are decades away, so you can comfortably invest in equity and ride out any volatility in the interim. However, when you are retired, the safest course of action generally is to invest primarily in risk-free or debt instruments.

“Investors should diversify their portfolios and should not put all their eggs in one basket. While fixed-income products do give priority to capital protection, investors also need to focus on returns," said Saurav Basu, head, wealth management, Tata Capital Ltd.

When investing, stick to your goals and asset allocation. Also, evaluate real returns, risks and liquidity.

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