FD vs mutual funds: Which is a better option for first-time investors?

Many first-time investors in the stock markets who enter through equity-focused mutual funds (MFs) often complain of high market volatility and bad experiences, so their involvement remains low.

However, I believe this is primarily a behavioral challenge that can be solved to a large extent by focusing on the sequencing of risk and expected return. Let me explain what I mean by that.

Many first-time investors in India have been conditioned since childhood to think about investing in a certain way.

The fixed income nature of traditional investments means that year-on-year (YoY) returns are very predictable and therefore there are no obvious risks associated with traditional investment products.

Traditionally, many investors do not think in terms of inflation-adjusted returns or real returns, and as such, although the return may be lower, the perception of risk is low.

Because of this conditioning, many first-time investors tend to view market-based investment opportunities in the same way and may not fully understand the relationship between expected returns and the risk taken on an investment.

For example, suppose a father wants to save for his daughter’s higher education at an ancestral school and the corpus will be needed in 15 years.

Let’s assume the cost at this point would be Rs 2 crore. This means that the investor can open a recurring deposit account with any bank that offers 7% interest per annum and must deposit Rs 743,825 at the beginning of each year for the next 15 years to end up with their desired corpus.

This is a really smooth and predictable solution. However, if there are problems such as Rs 7.4 lakhs every year for a specific destination then it becomes imperative to look for alternatives.

In this scenario, an investment product that can generate a higher return, and therefore lower annual rates, can do the trick.

However, there is a small problem. (The figure above serves to understand the investment concept and is not a planned return).

The sequence of returns on a market-linked product is non-linear compared to a traditional recurring deposit. For example, if the markets fall by -15% in the first year, the required return for the next 14 years increases from 7.00% to 7.25% with the rate remaining constant.

If we assume that equity markets return 7.25% yoy, ie no volatility in returns, and there are no more hiccups, then the objective is achieved.

Let’s also consider scenario 2 hypothetically and assume that in the next 14 years there is a specific year, say the 10th year, when the markets deliver an above-average return of 20%.

In this case, the target corpus is reached in the 14th year itself. Of course, this can work the other way as well and there could be a sharp drop in the markets just as one nears the maturity of one’s target, which may prevent reaching the final corpus.

This is what happened to many investors in March 2020, when Covid-related disruptions led to a significant drop.

As a rule of thumb, it’s therefore wise to keep switching to less risky investment options as you approach your target date.

However, this nuance must already be built in when preparing the financial plan, since each individual’s situation is unique.

A trusted financial advisor can help immensely in creating the plan and then navigating and reviewing it. (The figure above serves to understand the investment concept and is not a planned return).

Overall, I think that the non-linearity of returns is still unfamiliar to many traditional Indian investors and therefore does not fully understand the benefits of long-term compounding and, in the first case, this disrupts the market with negative returns and increased volatility.

As I said, this is more of a behavioral challenge and there are two solutions that have emerged in the Indian mutual fund space.

First, the emergence of the Balanced Advantage Funds category, which, by their product design, strives to offset this market volatility and provide investors with a journey they can feel reasonably comfortable with in terms of risk-reward tradeoffs. Second, the focus is on goal-oriented investing and asset allocation.

Let’s take an illustration again to better understand this. Suppose an investor, Mr. A, who started investing in 2010 and based on the returns of various indexes over the past 1 year, decided to invest in the Smallcap Index as it was the best performing index.

He remains invested for the next 3 years and at the end of year 3 in early 2013 he assesses his portfolio return and finds that the small cap index has underperformed the markets and notes that a financial services sectoral index has performed well , and decides to switch to this category instead and stay reinvested for the next 3 years.

After 3 years, when it comes time to review his investment at the beginning of 2016, Mr. A realizes that it was indeed the smallcap index that outperformed all other categories.

Mr. A realizes his mistake and switches from the Financial Services Index back to the Smallcap Index. The cycle repeats itself and in its next flashback in early 2019 it’s the same pattern again.

The smallcap index has underperformed and this time another FMCG industry index has outperformed. In a confused state of mind, he decides to chase returns and switches to the FMCG index, hoping this time will be different.

However, in early 2022, the FMCG index is proving to be an underperformer. How do you see the next 3 years to 2025 and if you were in Mr A’s place, what would you do now?

On the other hand, let me give you the last 12 years of data points for the Nifty 500 Index (the benchmark for most Flexicap funds) and

Hybrid 50:50 Moderate Index (benchmark for balanced benefit funds).

These two indices are based on the CAGR over the last 12 years and would have outperformed Mr. A by a fair margin. The Nifty 500 TRI Index had returned 12.2% and the Crisil Hybrid 50:50 Moderate Index had returned 10.7% on a CAGR basis, while Mr. A’s strategy would have returned 7.4% . (Source:

MFIE. The above serves to understand the investment concept and does not represent planned returns).

In summary, a simple buy and hold strategy may work better. I have a feeling this is the case for many investors because they miss the importance of risk-return order and periodically disrupt and expose the overall portfolio to higher volatility, eventually resulting in sub-optimal solutions.

https://economictimes.indiatimes.com/markets/stocks/news/fd-vs-mutual-funds-which-is-a-better-option-for-first-time-investors/articleshow/94957426.cms FD vs mutual funds: Which is a better option for first-time investors?

Russell Falcon

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