How to tackle the investment Catch-22 situation

I find a general consensus being built in business newspapers regarding the fact that the markets are getting overheated. Analysts have all started singing the same tune — that a correction is round the corner.

Never mind the fact that these so-called analysts have almost always been caught on the wrong foot. But today’s piece is not about stock market gurus and story-tellers.

It is about the age-old dilemma that an investor faces — while the markets are high and pose a certain degree of increased risk, fixed-income avenues offer no succour. Fixed deposit rates at around 7.5% per annum do not even cover the actual inflation rate.

So what should you do? How can you ensure the safety of your money and yet earn an attractive return? How do you have your cake and eat it too? Or is it possible for you to invest in the stock market without undertaking any risk whatsoever? Perhaps you can, if you structure your investment in a specific manner.

But first a little background on the profile of the investor we are considering. You are the typical 45+ investor. While you would like a healthy return on your investments, your life situation in terms of family responsibilities, EMI payments, possible medical expenses in the future etc, don’t allow you to undertake much risk. So while on the one hand, fixed-income investing doesn’t leave much in hand after tax, at the same time, you are not too thrilled with the risk and volatility associated with equities. So what do you do?

How do you come out of this Catch-22 situation?
We shall consider for the purposes of this discussion an investable amount of Rs5 lakh. Here I would like to impress upon readers that the exact amount doesn’t matter, it might as well have been Rs5,000 or Rs50 lakh—the principle will not change.  In other words, the concept is important, not the figures. If your investment amount is different, invest proportionately.

So, let’s assume that you have Rs5 lakh. You want to invest it well, preferably in equity, but with minimal or no capital risk. I like the sound of the words “with no capital risk” more than “with minimal risk”. So let’s devise a strategy of investing a lump sum in equity with no risk.

Here’s what you do. Out of the Rs5 lakh, invest around Rs3.87 lakh in any five-year bank fixed deposit (FD). Nowadays, FDs are offering 7.5% pa or 5.25% pa after tax (assuming a 30% tax rate).
Therefore, over five years, Rs3.87 lakh would grow to Rs5 lakh at the post-tax interest rate of 5.25% pa. So no matter what happens, five years later, you will receive Rs5 lakh. However, now you have a lump sum of Rs1.13 lakh left over. Invest this amount in an equity mutual fund.

No matter what happens to the money invested in MFs, after five years, the capital invested in the FD is going to net you Rs5 lakh, which is what you originally started out with. The market value of the Rs1.13 lakh invested in equity is just additional icing on the cake. To see how this strategy can actually work out, here are some numbers. Say you purchased the FD in September 2005.

The balance amount was invested in HDFC Top 200 Fund on a lump-sum basis. Now, the Rs1.13 lakh invested in HDFC Top 200 in September 2005 would have grown to around Rs3.68 lakh in five years. This amount is tax-free. Add to it the FD return of Rs5 lakh and the total investment would net a cool Rs8.68 lakh. Not only have you protected your capital but you also get the long-term benefit of equity.

However, there is one caveat. For a moment do not assume that I am implying that such returns would be repeated in the future. It is possible and at the same time it is not. However, readers will appreciate that there is no way of trying to judge the future except by the past. All I am saying is that such a structure ensures that no matter what happens to the equity investment, the base capital that you had begun with stays intact.

The new capital protection funds that are being launched nowadays use a similar mechanism. However, note that none of the fund houses actually guarantee (they aren’t allowed to by Sebi) that the capital is protected. The offer document may at best contain a mention that the schemes are oriented towards capital protection with a high degree of certainty but they don’t actually guarantee it.

Also note that the structure explained in this article, if adopted by the investor, essentially guarantees his capital.

There are no ‘degrees’ of certainty involved, just plain old pure certainty. I have said it in the past and will do so again — a steady job and a mutual fund is still the best defence against spiraling inflation.

The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com