Question

Discuss the argument whether lumpsum is 100% risk free for the owner or not with an

example.

Answer 1

For risk free equity investment, you can follow either of two approaches depending on whether your investment is a lump sum or SIP (at regular intervals). I prefer lump sum investment as it is not speculative. On the other hand, SIP approach is similar to the investment strategy of capital protection funds. Let’s understand.

(a) Lump Sum Investment: In this case, i will invest 100% investable amount under 100% safe and secure financial instrument. In the case of a fixed deposit, i will opt for monthly interest payout. In the case of Arbitrage Mutual Fund, i will opt for Systematic Withdrawal Plan. The key point to consider is that you have to take care of taxation part. Depending on your tax slab, you may opt for FD or Arbitrage Mutual Funds. The people who are in the lower tax bracket of 10% may choose for FD. An investor who is in 20% or 30% tax bracket may opt for Arbitrage Mutual Funds.

In an ideal scenario, you invest in Arbitrage mutual fund. Wait for one year and then start risk free equity investment. The reason being, any withdrawal from Arbitrage Mutual Fund is Tax Free after one year. In short, the capital gain tax is not applicable. It is more beneficial for all tax slabs. Secondly, if you withdraw equity investment before one year, then you need to pay short term capital gain tax. Therefore, please consider all taxation factors that vary from case to case basis.

Let us understand with an example. Say i invested Rs 5 lac in Arbitrage Mutual Fund. Considering a conservative post-tax return of 7.2%, i can withdraw Rs 3,000 per month. My principal investment of Rs 5 lac will remain intact. The best part of Arbitrage Mutual Fund is that returns are almost consistent and at par with Fixed Deposit returns. Now for risk free equity investment, i will invest withdrawal amount of Rs 3,000 in stocks. The investment is risk free equity investment. There is no fear of losing the principal.

As we discussed in other posts also, that long-term returns on equity are 9%-10% with HIGH RISK. To match these returns, an investment of Rs 3000 per month i.e. annual investment of Rs 36,000 should be Rs 50,000. It is not possible during the first year, but you can aim these returns from second year onwards. It is feasible with lower investment amount as you are in FULL control of your investments. The portfolio is less concentrated. You can identify high alpha stocks and also time the market. This approach is entirely risk-free, and you can realize the dream of risk free equity investment.The only word of caution is that you have to time the market.

(b) SIP Investment: This approach is similar to capital protection fund. Depending on the projected return and maturity value, you can invest a portion of total SIP value in equity. For example, if i have to invest Rs 100 on a regular basis and expected the return of 8% in a safe investment. In this case, I will invest Rs 93 in a safe investment and Rs 7 in Equity. After one year Rs 93 will become equivalent to initial investment amount. The value of Rs 7 at that time will be your returns. Unlike the first approach, this approach will not have any taxation issues as you are investing month on month. This approach is more tax friendly compared to the first one. Only at the time of withdrawal, you need to consider taxation of same.

Words of Wisdom: As a thumb rule, you should invest in equity once you are convinced that markets will deliver positive returns. By following the approach mentioned above, you can generate alpha returns over debt returns in a risk free manner. Secondly, this approach is more useful for first-time equity investors to test waters. The risk free equity investment gives peace of mind to conservative investors. At the same time, they learn the rules of the game. Once you are comfortable with equity, you can increase allocation to equity. It can be done only if you are convinced to cover up the loss of safe investment. It is a doubled edged sword if risk free equity investment fails to deliver the desired result. Still the overall risk will be LOW compared to high equity exposure.

Lastly, the approach of risk free equity investment is more suitable during volatile times when you are not sure of market movement. It gives confidence to the buyer. During my experimentation in past with risk free equity investment. I can say with 100% guarantee that your risk free equity investment cannot be done.

Hope you like my explanation.