Read to know how you can earn 15% annual returns on your investments

Thursday, September 22, 2016 Swati Aggarwal 0 Comments

Read To Know How You Can Earn 15% Annual Returns On Your Investment

In this article we describe an approach as to how investors can build a portfolio to achieve their target returns. But if you are really impatient, you can directly jump to the section on ‘The 15% returns portfolio’. However remember that no advice is suitable for every investor, so do definitely read our ‘Should everyone buy this portfolio’ section on how this portfolio may or may not be appropriate for you.

To earn returns you need to take risk. Period.

So you are looking to earn a certain return – say 15% per annum – on your investment? The first number that you should consider is the risk-free rate (loosely interpretable as the rate you earn on bank deposits) in the country. In India the risk free rate (as set by the RBI) is ~7%. In the US, it is currently close to 0%. Why is this important? Because if you are looking to earn anything above the risk-free rate you need to be prepared to take some sort of risk. If you are looking to earn 15% per annum in US, be prepared to take an insane amount of risk. In India, thankfully the task is easier.
Now that we have established that you need to take some amount of risk over an above a simple bank deposit, the question is what kind of risk to take. We list below a (hopefully) comprehensive set of things you can do, in the order of least risky to most risky.

  1. Interest rate risk: You can choose to lend out your money for a longer period of time than in bank deposits. This can be done in a number of ways –  long term FDs, small saving schemes such as PPF, NSC , Sukanya Samriddhi etc.  However one issue with these schemes is that you are actually locked in for the period of time for which you are investing your money. Investors can withdraw early but with penalties. One way to lend money for the long-term while retaining the option to exit early is by investing in instruments where a secondary market exists such as 10yr government bonds. With 10 year government bonds for instance, you can earn the current 10 year interest rate but in case you need your investment amount before 10 years you can get that by selling the bonds to somebody else.  You can either invest in longer term government bonds directly or through debt mutual funds which invest in these securities.
  2. Credit Risk: With government bonds, you lend to the government which is the highest credit in the country. But you can also choose to investment to lower credit investors like corporates and increase your yield. The increase in yields that you get is directly linked to the credit quality of the issuer. For instance, PSUs are usually considered low credit risk because they are seen to be in some sense backed by the government. Hence the increase in yield that you will get by investing in PSU debt over government debt will be low. You can get a greater yield pick-up by investing in riskier corporates. The credit rating of an issuer is an indication of its credit quality/probability of default. Investors can take credit risk by investing in corporate FDs, corporate bonds etc.  Or they can simply invest in mutual funds which invest in these securities.
  3. Market risk: By market risk we mean Equity market risk. Equity markets are a proxy for a lot of things – GDP growth, low and stable inflation, stable political situation, reasonable current account deficits and just a general sense of well being. You can take the risk that good times will continue and further increase your returns by investing in equity markets. There are so many ways of investing in equity markets that it deserves a blog post but in very short, investors can invest either in the entire equity market or some segment of it like large cap, mid cap or small cap or in certain sectors such as banking, IT etc.  Large cap stocks or stocks of big companies are generally considered to be less risky. Smaller cap stocks are considered riskier. Further diversified equity exposure is considered to be less risky, while going for a concentrated portfolio either by investing in a few sectors or just a few stocks is riskier. As you would have guessed by now, more risk also equals potential for higher returns.  Further in each of these areas, investors can either invest through mutual funds which focus in that area or but shares directly themselves. However unless and until the investor is being really selective about the stocks they want to buy, investing in funds is probably easier.
In addition with each of these risks, you can decide to go to public markets. Or you can take additional illiquidity risk (risk that you will not be able to withdraw your money at any time) and lend to local businesses, invest in private equity etc. This can increase your yield further.
Finally apart from financial assets investors can also invest in real assets such as real estate and gold. In general, these do better (worse) than financial assets when inflation is rising (falling).

Diversify. Diversify. Diversify.

Or to put it simple terms, don’t put all your eggs in one basket. Whatever return target you have in mind – 15% or anything else, never ever invest all your money in one singe risk. Different assets do well at different times. For instance during times when growth is high equities typically do well and bonds do badly. But when growth slows down like in 2008, the reverse happens. Similarly when rising inflation is a concern like in 2013, both equities and bonds may underperform but a real asset like gold may do very well. Hence by keeping a little bit of everything in your portfolio, you are much more likely to get consistent returns around your target.
 Portfolio construction is a much researched area, including Nobel-prize winning research. Without going into too many mathematical details, portfolio construction should at least take into account the return and risk of the different asset classes available and to what extent these asset classes can diversify each other.
Fortunately ORO has already done the hard work for you. We have built 11 portfolios with different return targets ranging from 8% to 18%, which have been constructed in such a way that the risk for any particular return target is kept as low as possible. If you have an ORO account, you can check out these portfolios     here. For the 15% portfolio, read on.

The 15% returns portfolio

According to us the following target allocation is a less risky way of getting 15% returns every year. Given the relatively high return target, there is no allocation to short-term debt such as in the money markets.

If we assume that we invest in this portfolio through index mutual funds (and deduct a representative expense ratio), then this is how the returns in the past years would have looked like (2016 returns only include returns till end of August). As you can see investing is still risky and there is a lot of variation that you find around the 15% level.  In its worst year (2008) the portfolio was down nearly -21%.  Anybody looking for 15% returns should make sure that they are comfortable with this kind of variation before they invest.

For investors looking for a different target return, they can see similar asset allocation and annual returns for their return choice here.
We have picked mutual funds for investing in this portfolio because they are convenient and applicable for most investors. They allow for easy entry and exit. With mutual funds, investors can gain access to the whole diversified portfolio even with a small investment amount – something which is not possible if investors try to build a diversified portfolio by buying equity shares themselves.  Further it is equally valid for large investors because there is no upper cap on investment unlike small saving schemes. These were also the reasons for preferring gold over real estate as the real asset in this portfolio.

Also, we have chosen index mutual funds (which just track a benchmark index) to show that these returns without even doing fund selection. Investors can of course do one better by making the right fund choices. But as you would probably expect by now, that comes with the risk of not doing as well if your fund choice was wrong. At ORO, we have a list of funds which we think are likely to outperform in their categories. You can check that list here.

Finally, these returns are also assuming that you invest in 0-commission direct plans with a provider like ORO (Access our investment platform). If you buy regular plans, then deduct ~ 1% from your returns every year which will go to pay commissions.

Should everyone buy this portfolio?

This simple answer is No. And that is because earning 15% returns comes with a certain risk and not everybody may be willing or able to take that risk. For instance if you are an investor with a 1 year investment horizon, then this portfolio is not suitable for you. As the chart above shows, in any single year this portfolio can give low even negative returns. Examples of such years have been 2008, 2011, 2013 and 2015. It makes up for these low return periods in the subsequent years but you will not be invested for that long! Hence this portfolio is suited for investors with a long investment horizon. Investors with shorter investment horizons, are better off investing in debt-heavy portfolios which will have lower returns but are more likely to be up in any single year due to regular interest. Similarly other considerations include the goal that you are investing for, how important is the investment amount to your networth, your general attitude towards risk etc.
 Eventually a holistic assessment of your personal circumstances is needed to decide on what is the right target return/risk for you. And building the right portfolio for that target return/risk is a (very important) follow on step. Further this portfolio will need to change as your circumstances in life change. At ORO advisory we provide all these three services to you. Check out ORO advisory today and experience the difference that professional financial advice can make to your returns.

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