InvestorQ : How do you compare returns of fixed income and equities which have indexation benefits?
Pratik vyas made post

How do you compare returns of fixed income and equities which have indexation benefits?

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Nitin Shah answered.
2 months ago
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There are various parameters you can compare the two from. This is just one of them. For choosing the right fit for your portfolio, you need to gauge various aspects of the two investment classes.  For simplicity's sake, I will compare debt mutual funds with equity mutual funds.

Both have their pros and cons, and the choice between the two depends upon your financial and risk profile. 

Risk: Debt mutual funds are considered lower in risk as they invest in instruments that yield a fixed income. This does not mean that they offer guaranteed returns – only a relatively more certain return. Equity funds typically invest in stocks of companies and have proven in the past to provide inflation-beating returns over the long term. The keyword is a long term, which I would like to define as 10 years or more. Risks involved should be in line with the investment objective and return expectation. The variation of returns in debt is usually small and therefore a long-term average of 8% implies that actual returns would be in a band of 7-9%. This means that there is a high degree of certainty that investors would get returns near the long-term average. The risk of losing invested capital is also very low. On the other hand, equities are volatile and their returns vary too. The risk of losing your invested capital is higher too. However, the longer the holding period, the lower is the expected volatility.  

 Returns: Debt funds can give you steady returns but in a constant range. Since debt funds invest money in treasury bonds, there’s much less risk associated with them. Debt funds are a good investment option when the market is volatile. As equity mutual funds invest in stocks and shares, there is a good probability of higher returns being generated as compared to debt funds. But as discussed above, there is also a risk involved in equity mutual funds as a result of which there may be negative returns as well. Typically, equity funds can generate returns in the range of 12-15% while debt funds' returns stand in the range of 8-10%. 

Taxation:  

A) Short term tax: A holding period of fewer than 36 months for debt funds and less than 12 months for equity funds is defined as short-term. Therefore, short-term capital gains tax (STCG) applies to income made from any debt scheme held for less than 36 months or 3 years, and equity scheme held for less than 1 year.

B) Long term: Long-term capital gains on debt funds are taxed at the rate of 20% after indexation. Indexation is a method of adjusting for inflation the purchase price of debt fund units at the time of sale. In the case of equity mutual funds and balanced mutual funds, a holding period of 12 months or more is regarded as long-term. So, long-term capital gains tax or LTCG applies to those investments. LTCG in excess of Rs1 lakh is taxable at the rate of 10% without the benefit of indexation. Below Rs1 lakh, LTCG is not applicable.

C) Equity-linked saving schemes (ELSS): In case you want to save taxes under Section 80C of the Income Tax Act whilst creating wealth, then ELSS is regarded as the most appropriate investment option. ELSS has the shortest lock-in period of 3 years and gives higher returns than other investments eligible under Section 80C Tax deduction.  LTCG is applicable on ELSS as well. To conclude, if you are a person who is willing to take a risk and is focused on creating wealth over the long term, equity mutual funds will be a better option for you. Alternatively, if you are a person who is risk-averse and prefers stable, fixed returns, then debt funds will work better for you. Parallelly, you can also invest in a certain combination of debt and equity mutual funds, which will help you attain an effective balance of risk and returns.
         
You also have the choice of including a proportion of equities and debt in your portfolio. They tend to work in complement with each other. Equities tend to give you inflation-beating returns while debt could protect the downside of your overall portfolio.
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