“Bank Fixed Deposits are not going to work for me! I am planning for building up a fund for paying off my daughter’s college fees.” Mr. Iyer was telling me the other day.
“I want to know where I can invest for 5 years so that I would be able to pay off the college fees easily after 5 years?” Mr. Iyer was indeed worried because he is not able to understand how to work this out.
Mr Iyer is a representative example of the common man to whom any of us can relate to. There are so many financial instruments in the market, then how to choose the correct one suited for our financial goal. Let’s see in this case study where Mr Iyer can invest fruitfully for 5 years in ELSS vs PPF Public Provident Fund
Let’s understand what are ELSS (Equity Linked Saving Scheme) and PPF (Public Provident Fund)
ELSS refers to Mutual Funds that invest 80% or more in equity i.e. shares and securities. ELSS is one of the primary tax saving instruments which has a lock-in period of 3 years. Investors can invest in ELSS in a lump sum or through SIP (Systematic Investment Plan). SIP requires that the investor should invest a fixed monthly amount in a selected ELSS fund.
PPF refers to another tax saving instrument which is a rather long term investment term of 15 years. The investors would be required to open a PPF account wherein he is required to invest monthly or annually.
The differences between ELSS and PPF
An investor needs to stay put in ELSS for the minimum period of 3 years to get a tax deduction benefit on the investment under section 80C
Lock-in period for PPF is 15 years which is much higher as compared to ELSS. Even though partial withdrawal is allowed after 5 years, substantial money will still be blocked till maturity.
Due to 3 years lock-in period, the investor can easily redeem or sell to quench its liquidity needs
Due to greater lock-in period, PPF can be touted as an illiquid instrument, more suited to long term financial goals like retirement planning etc.
Returns and risk ratio
ELSS has a moderate to higher risk and returns ratio since 80% or more of the funds are allocated towards shares and securities in the open market. Returns could be on an average 10-13% p.a. The risk could be in the corresponding % due to market uncertainty
PPF has a lower risk-return ratio since it is a government scheme. Returns could be around 7-8% as dictated by government. Risk is very less since the returns are guaranteed by the government
Investment in ELSS is covered under section 80C deduction, however, the capital gains are taxable above the limit of Rs.1 lakh
PPF has an EEE structure meaning that investment, returns, as well as maturity proceeds, are exempt from the income tax purview.
Let’s compare ELSS and PPF for Mr. Iyer
I showed all this data to Mr. Iyer who was again confused, “Anna, it looks like both ELSS and PPF have their pros and cons. How would I know which one is better for me?”
So here is the comparative chart where it is assumed that Mr. Iyer invests Rs. 5000/- per month in ELSS and PPF.
The amount received annually if Rs.5000 invested in ELSS
The amount received annually if Rs.5000 invested in PPF
*assuming that ELSS earns a rate of return around 11.5% and PPF earns around 7.1%
Analysis of the case study
Looking at lucrative returns earned by the ELSS, ELSS definitely makes a good option for a 5-year investment option
However, while considering the higher rate of return, we also must attach the risk carried by ELSS in the form of unguaranteed returns and loss of principal.
PPF returns even if secure and easiest way for investing, definitely takes a toll on the liquidity stature of the investor. Since PPF allows only partial withdrawal after 5 years, there is no chance that Mr. Iyer could take out money before that threshold.
PPF is the most secure form of investment since it is backed by the government. Even if the rate of return does not factor in the inflation cost, there is no default risk or market risk in PPF.
If we keep on populating the returns for both ELSS and PPF for a longer period, ELSS would bag the surge in returns in the long term considering that markets will be in the progressive mode of operation.
I suggested Mr. Iyer take an independent decision based on the below pointers. Hope it helps you all too to take a big leap.
If Mr. Iyer wishes to conserve the capital and is wary of the stock market, then he can put his money in PPF. This would give him the guaranteed returns and security of principal invested. However, the con side to this would be
Comparatively lower returns
No inflation factoring of returns
The long term Lock-in period of 15 years resulting in a liquidity crunch
If Mr. Iyer has a moderate to high-risk appetite, then he can think of putting his money into ELSS funds to secure a higher rate of return. ELSS would be a very liquid asset as well as a high return bracket. However, there are few risks to think of
Loss of principal due to market risk
Alternatively, Mr Iyer can divide his investment in PPF and ELSS to reap higher returns and square off the losses.