Equity investments need close monitoring even if they aim at a goal 15 years away
Real estate is perceived as a safe investment. This is not because land prices have risen sharply over the years. The stock market, too, has climbed sharply. Yet, most believe (and rightly so) that equity investments are not safe. The reason, perhaps, has to do with price visibility. You can observe stock prices and, therefore, perceive the associated volatility. Real estate could be perceived as safe because prices are invisible. Can you draw such comfort from equity investments by distancing yourself from the market? Here, we show why the return-characteristics of equity investments and the current tax structure could hinder any strategy to make equity prices ‘invisible.’
Real estate is lumpy and illiquid. Also, it generates supplementary cash flows in the form of rental income. For these reasons, you can look at the realty market only when you want to sell property, not otherwise.
In contrast, you need to closely monitor equity investments even if those are meant to achieve a life goal 10-15 years later. This is because of the return-characteristic of growth productsdiscussed previously in this column.
Your equity investment has to go up by a larger percentage to recover losses than it will have to decline to wipe out gains for the same initial change in value. For instance, a 50% increase in investment value will require only a 33% decline to wipe out unrealised gains. On the other hand, a 50% decline in value will require a 100% increase in value to recover unrealised losses.
You could, therefore, risk losing your unrealised gains or increase your unrealised losses if you distance yourself from your equity investments. But, what if you invest in the dividend option of active funds?
An active fund is expected to generate higher returns over its benchmark index through active portfolio management. The issue is profit from active management will remain in the fund’s portfolio unless you redeem units in the fund. But, redemption requires you to continually monitor your fund’s performance! That is why choosing a dividend option in an active fund could help.
The dividend option allows the fund to return cash to you when the fund manager considers it appropriate. Note that cash flows from the fund to its unitholders may contain both dividends the fund receives on its investments and the fund’s realised capital appreciation.
Of course, this strategy will be effective only if you pick an active fund that generates decent excess returns over its benchmark index and pays dividends at appropriate times. But, choosing an active fund is not easy. Note that an index fund does not take profit to capture unrealised gains in its portfolio because the fund passively tracks an index. Therefore, buying the dividend option of an index fund will not help you distance yourself from your investment.
You may have to review your portfolio annually to align your equity investments with your goal, even if you invest in a dividend option of an active fund. Why? Suppose you require 10%compounded annual return on equity investments to achieve your goal. If the fund generates 11% in a year (excluding dividend payments), you should take profit totalling one percentage point of your fund investments to protect unrealised gains in excess of your expected return.
Finally, dividends from equity mutual funds are taxed at your marginal tax rate whereas capital appreciation (long-term or short-term gain) attracts a lower rate. You could consider the higher taxes on dividends as a cost for improving your emotional well being, distancing yourself from equity investments to moderate perceived volatility. Whether this strategy will provide sustained level of emotional well being is moot.
(The author offers training programmes for individuals to manage their personal investments)