Why lock-in is good for bonds but bad for equities

Investment liquidity should be based on source of returns, not on the length of lock-in periods

ELSS (Equity Linked Savings Scheme) has a shorter lock-in period than the public provident fund (PPF). So, individuals prefer ELSS as a tax-saving investment. In this article, we discuss why investment liquidity should be based on the source of returns, and not on the length of the lock-in period.

Upside versus downside

Your goal-based investments should have a lock-in period! Why? We typically lack self-control. That means, we have to be nudged to save for the future whereas spending comes naturally to us. This is because we suffer from present bias; now is better than the future.

So, spending today gives us more happiness than saving for the future. Now, relate present bias to your goal-based investments. Suppose you are investing to make a down payment to buy a house five years hence. If the returns on this investment is credited into your savings account every year, you may be tempted to spend the money for purposes other than what it was intended for.

The easier it is to take out the investment, the more likely you will. Lock-in is an external mechanism to protect your investments from you! That said, lock-in is not always good. Your decision to choose an investment with a lock-in period should be based on the source of returns on the investment.

Most investments offer income returns and capital appreciation. Your goal-based investments should be created to earn interest income on bond investments and capital appreciation on equity investments; bonds provide stability whereas equity offer upside returns. You should lock-in your bond investments through the time horizon for your life goal, but not your equity investments. Why?

Suppose your initial investment in equity increases in value from ₹ 100 to ₹ 125. Your unrealized gains of 25% can be wiped out if the investment declines by 20% (25 upon 125). On the other hand, suppose your investment declines to ₹ 75. Your unrealized loss can be recovered only if your investment increases by 33% (25 upon 75). This suggests that it is easy to lose unrealized gains, but it takes more effort to recover unrealized losses.

Now, what if your investment carries large unrealized gains or gathers unrealized losses during the lock-in period? You may want to take profit to protect your existing gains or take losses if you expect the investment to suffer further declines. But you cannot exit your investment because of the lock-in period.

Conclusion

Lock-in period for equity investments is not good because the primary return on such investments is from capital appreciation. True, the three-year lock-in period for ELSS is significantly shorter than the 15-year lock-in for PPF. But PPF is an interest-earning investment compounded every year without suffering downside risk.

In addition, the lock-in period saves you from spending the interest income. On the other hand, ELSS exposes you to the risk that the market may decline during the lock-in period, either reducing your unrealised gains or accumulating unrealised losses.

Your inability to take action during the lock-in period could hurt your chances of achieving your goal. You should, therefore, invest in regular equity funds that do not have a lock-in period. And invest in income-generating products with lock-in period whose maturity aligns with the time horizon for your life goal. For instance, if you are accumulating money to buy a house after five years, invest in a five-year recurring deposit. Of course, you can break your deposit before maturity but that comes with a huge penalty.

The trick to managing investment discipline is this: First, choose bond investments that do not credit interest income into your savings account till the maturity of the investment. And second, take profit on your equity investments every year if unrealized gains are higher than your expected return. This will reduce the risk that all your unrealized gains will be wiped out during market declines.

(The author offers training program for individuals to manage their personal investments)

Disclaimer: This post has not been edited by our staff and is published from a syndicated feed. The Original Source of this post can be found at Source link

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