As an investor, you invest in mutual funds to earn a higher return than your other investments. The benchmark that you use is of past returns and hence your expectations are also high. For some, they are not sure what to expect.
Let’s try and use a data based approach to determine these expectations.
So, what returns do you expect from your mutual funds?
Actually, it depends on what kind of a mutual fund you invest in.
- Pure Equity
- Pure Debt
- A mix of both, a balanced or hybrid fund
A pure (diversified) equity fund is expected to give returns in line with the long term average GDP growth rate over the years.
A debt fund is expected to give returns in line with average historical interest rates and inflation.
With a mix of both, you can use simple arithmetic to derive a weighted average return.
Let’s see what data has to say in support of this argument.
How much returns to expect from equity investments?
GDP Annual Growth Rate in India averaged 6.08% from 1951 until 2016, reaching an all time high of 11.40% in the first quarter of 2010 and a record low of -5.20% in the fourth quarter of 1979.
GDP growth rate chart for 10 years
If GDP growth rate was an indicator of a diversified portfolio, then we should expect 6% to 7% of real GDP growth over the next decade or so. However, that is the real GDP. We need to add the inflation to bring it to the nominal level.
Inflation Rate in India averaged 7.38% from 2012 until 2016, reaching an all time high of 12.17% in Nov 2013 and a record low of 3.2% in Nov 2014.
Inflation chart for 10 years
To raise it to a nominal level, add the inflation rate of 7% to 8% to the GDP growth rates of 6% to 7%. Thus nominal GDP is expected to grow at 13% to 15% year on year for the next 10 years or so.
GDP of the economy represents a fully diversified portfolio across sectors and industries reflecting average equity returns of 13% to 15%.
Equity Mutual Funds too are expected to deliver a similar return since they represent a diversified portfolio of stocks.
What should you expect? It is recommended to expect a lower number and plan your investments accordingly.
How much returns to expect from debt investments?
Estimating returns from debt / bond investments is far more complex. There are many variables that influence interest rates and thus the returns from debt instruments.
Usually, inflation and interest rates tend to be in sync.
We saw the inflation growth chart above and the average was around 7.38%.
Interest Rate in India averaged 6.70% from 2000 until 2016, reaching an all time high of 14.50% in Aug 2000 and a record low of 4.25% in Apr 2009.
Interest rate chart for 10 years
The averages of inflation as well as interest rates converge closely.
So, we can expect a return of 7% to 8% on an average for our debt or bond investments.
What will be the portfolio returns that has a mix of equity and debt?
We now have 13% expected returns on one side from equity and 7% expected returns on the other side from debt/bonds.
If you invest 50:50 in each of these, your weighted average returns is expected to be (0.5*13%) + (0.5*7%) = 10%, before taxes.
If you invest in the ratio of 80:20 for equity:debt, then your expected weighted average return would be (0.8*13%) + (0.2*7%) = 11.5%, before taxes.
How to calculate the return of your portfolio?
Here’s a quick way to calculate the returns of your portfolio.
- List down your own investments in various investments including EPF, PPF, NPS, Traditional insurance, Stocks, Mutual Funds, etc.
- Then list the allocation of debt and equity in each of the investments. For example, your NPS may have a 50:50 allocation to debt and equity.
- List down the expected return from each. This is because, in some cases, such as traditional insurance, the debt may also end up providing a much lower return.
- Multiply the weight or % allocation of the investment with the expected returns.
- Sum up all the weighted returns to get your expected portfolio returns.
Check: What were you expecting from your portfolio? Is this enough to meet your goals?
One of the aims of financial planning is to understand if the rate of return is enough for you to reach your goals and how you can change the mix of the investments in your portfolio to achieve the required rate of return.
We will take this up in a subsequent post with an example of retirement planning. Watch out.