Equity should yield returns which are higher than the risk free rate of return from investment in government bonds.
Today, we will talk about the money we have with us and the options at our disposal. As a small retail investor, we are looking at building wealth all our life and we slog towards that so that when we retire we have a peaceful life.
In this environment when almost every consumable thing has become extremely expensive, I have assumed a nominal saving of Rs. 5,000 a month. Now, what do we do with this saving? Let’s say we have Mr. A, who is a classic example of eternal pessimist. Such a person has his theory of not trusting anyone in this world.
He likes to retain his savings and not invest or hand it over to anyone. He keeps his accumulated wealth in a bank locker or keeps it at home. Such a person if at age of 30 does this process for next 30 years, so in the end he will end up with accumulated savings of Rs. 18 lakh (Rs. 5000 per month @ 12 months for 30 years =>5 X 12 X 30).
Now, we have Mr. B who is one step ahead of Mr. A, and trusts only government. He is willing to invest in only government bond, which fetches him an interest income @ of 6% per annum. This Mr. B will accumulate Rs. 50, 47, 688 (Rs. 5000 per month @ 6% for 30 years).
Mr. C is less risk averse and is willing to park his surplus with bank deposits which yields him interest @ 8 % per annum. Mr. C will be richer and his wealth will be a mammoth Rs. 75, 01,475 (Rs. 5000 per month @ 8% for 30 years).
We also bring in Mr. D who is a risk seeker and is willing to invest in corporate debts which give him interest income of 10%. He becomes a crorepati with accumulated wealth of Rs. 1,13, 96,626 (Rs. 5000 per month @ 10% for 30 years).
The counter argument to Mr. D becoming a crorepati lies in the assumption that a corporate continues to pay him interest income of 10% for continuous tenure of 30 years. There are built-in risks and it is possible that the corporate might default in paying interest and capital. In short Mr. D’s investment carries risk.
Mr. C’s investment is safer, while Mr. B is safest as it is perceived and widely believed that government does not default or delay its interest payments.
How is all of this linked to equity?
Well if anyone is looking at investing in equity thenthe bare minimum return that should be expected from equity should be higher than the risk free rate of return which is expected from investment in Government Bonds. In our example that rate is 6% which is Mr. B’s choice of investment.
The learning we have today is that equity should yield returns which are higher than the risk free rate of return from investment in government bonds. So today, we have learnt a lesson which captures the opportunity cost of investing in equity.
In simple terms, if the alternate investment yields 6% without risk, then certainly it is fair to assume that when one invests in equity, the return expectation is certainly higher than that.
For more such expert blogs and guidelines, visit www.itsallaboutmoney.com
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