Debt funds or equity funds? The right answer may be 'both'
Equity, on the other hand, is an essential asset class for the long-term growth of savings with returns that beat inflation. Equity funds typically invest in stocks of companies and have proven in the past to provide inflation beating return over the long term. The key word here is long term, which we would like to define as longer than 7 years.
November 20, 2014 / 08:52 AM IST
Given the thousands of mutual funds that you can invest in, picking the right one to put your hard earned money in can be a challenging task. But even before you pick the right scheme, you must decide whether you want to invest in Equity Funds or Debt funds. The answer is different for different investors and this article explains the criteria you should consider.
Understanding the key differences between Debt & Equity funds
Debt mutual funds are considered lower in risk and invest in instruments which yield a fixed income: such as government bonds, company debentures, commercial paper and company fixed deposits. This does not mean that they offer guaranteed returns – only a relatively more certain return. What makes debt funds attractive over other similar options like FDs is their tax efficiency which leads to superior post-tax return. These are not high returns but at least at par with the rate of inflation.
Equity, on the other hand, is an essential asset class for the long-term growth of savings with returns that beat inflation. Equity funds typically invest in stocks of companies and have proven in the past to provide inflation beating return over the long term. The key word here is long term, which we would like to define as longer than 7 years. This is not that long because most of the money investors save stays invested for approximately a period of 40 years and equities is where most of this money should be invested.
However, duration of investment, while an important criteria, may not be enough to decide where to put your money and you must also consider some others.
Deciding between Debt vs. Equity
• Investment objectives - The objective could be to income generation or wealth creation. Debt is advisable for those looking to generate income through their investments because it provides more certainty of return. However for growth and wealth creation, equities would be a better option depending on the investment duration and return expectation.
• Investment duration - Investors should select the asset class based on the time period at the end of which they will need the money, for example, 20 years. Debt funds are better for shorter durations, preferably 5 years or less. Equity funds should ideally be held for duration longer than 5 years.
• Returns expected - A number of investors choose an asset class (Debt or Equity) with unrealistic expectations. Returns from each come with varying degrees of risk and uncertainty. On a long-term average basis, returns for debt are in the region of 9% and equity in the region of 16%.
• Risks involved- Risks involved should be in line with investment objective and return expectation. The variation of returns in debt is usually small and therefore a long-term average of 9% implies that actual returns would be in a band of 8-10%. This means that there is a high degree of certainty that investors would get returns near the long-term average. The risk of capital loss is also very low. On the other hand equity returns vary in a broad range. There is also a high risk of capital loss due to this. However, the longer the holding period, narrower the range of returns variation. In a simplistic way the decision between equity and debt is the decision between almost certain 9% return and an uncertain 16% return.
• Tax applicable – Equity investments are highly tax efficient with zero tax for holdings longer than 1 year. Debt funds, on the other hand, attract short-term capital gains tax before 3 years and long term capital gains with indexation after 3 years. For an investor investing for longer than 3 years, there is no difference in tax between equity & debt.
The decision is therefore a complex one involving many parameters. To make it simpler, we recommend that while being aware of all criteria, you choose one criterion that is most important to you and make your choice.
Once the selection is made, investors can take the next step of picking up the right funds in the selected asset category. It is important to select funds solely based on facts and data rather than brand names. You should diligently research and analyze fund performance before investing your money. Your decision should ignore personal preferences, un-informed recommendations, advertising and brand names. To help you with your decision, various websites track fund performances and make this data freely available. If you lack the inclination or expertise to understand these figures, there are few automated platforms which recommend pre-selected portfolio of right funds to invest in.