Tuesday, October 30, 2007

Financial Foolishness

Came across the following article in a mainstream financial newspaper in India:

Mutual Funds Best Bet to Beat Inflation

The sheer stupidity of the article is staggering.

See, for example:

"he said even a regular investment of a small sum of Rs 200 a month through the Systematic Investment Plan (SIP) route for 6 or 7 years would fetch an investor Rs 12 lakh after 20 years subject to an annualised return of 10 per cent"

Now supposing the investor does better and invests 200x12x7 = 16800 right at the beginning. Compounding a non-inflation-adjusted return of 10% (as claimed) leads to a multiple of 1.1^20 = 6.72. 6.72 times the original principal = 112896.

Counting in inflation at 5% per annum, the multiple reduces to: 1.05^20 = 2.65, giving an inflation adjusted return at the end of 20 years = 44575.

It doesn't look as spectacular, correct?

Let's look further:

"In today’s scenario, the stock market would provide a return of 20-25 per cent annually."

Not so, that has been the historical long term performance of Sensex over 20 years (where individual years at times gave negative returns), inducing future performance from the past is completely irrational.

"When the returns are 20 per cent, the maturity value at the end of 20 years would be doubled to Rs 24 lakh. Investment of Rs 500 every month could get a return of Rs 30- Rs 35 lakh after 20 years whereas the actual investment is only for 6 or 7 years. No other savings could match the return provided by MFs."

Alright, let's calculate. Suppose the investor invests 500x12x7 = 42000 right at the beginning, and earns a non-inflation-adjusted return of 20%. Over a 20 year period, the compounding multiple of principal = 38.33. Asset value = 16 lakhs. (when it is claimed to be 30-35 lakhs).

Counting inflation of 5%, the returns are only 16 times = 672000.

Assuming, of course the following:

1. The market is not in a temporary crash after 20 years (which might take 5 more years to get out of).

2. The market behaves in the long term and the investment does not get blown up.

3. One discounts MF loads, brokerage charges and MF management charges.

Finally, the piece-de-resistance:

"Offering a personal example, he said `believe me or not, I am investing and making money only after reading the business column in the Business Line.'"


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