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How ELSS can be your stepping stone to long-term equity investments

Blog Blog Details
  • December 23, 2020
  • Umang Thaker|
  • Head of Products

The default feature of equity lock-in prevents investors from making hasty redemptions

Investors wanting to achieve the basic arithmetic combination of saving taxes and building wealth — both at one go — can consider investing in Equity Linked Saving Schemes (ELSS). A lot is already written about the twin virtues of tax benefits and equity investments, but one attractive feature that is rarely talked about is the default ‘lock-in’ feature.

Understanding the ‘default effect’

“To do nothing is within the power of all men,” said Samuel Johnson.

The ‘default effect’ is the phenomenon where making an option the default among a set of choices increases the likelihood of it being chosen.

Defaults in our daily life have evolved consistently — voice commands have replaced typing, thumb impression has replaced keys and, in the near future, driverless cars are likely to replace drivers. From pre-filled web pages to the size of coffee cups, from ‘web apps’ with standard settings to public policy, the ‘default’ option has surely proven its utility.

One would wonder why the ‘default setting’ is the most preferred option. Reason: it saves the user from the trouble of decision making.

The key culprit is ‘effort’. Because choosing something that is not default requires effort. The amount of effort required may be different — and only if the perceived reward of effort is greater than the input, will a user be willing to invest time in making changes.

Power of good defaults

Today, the ‘Default Effect’ and ‘Nudge Theory’ are widely used as effective tools in administering public policy. The US administration uses the principles of Nudge for encouraging long-term savings in its pension policy. Making enrolments a default option ensures a higher rate of participation and hence higher retirement savings.

Austria and Sweden presume consent for ‘Organ Donation’, making it a default. People who do not wish to donate their organs have to fill an opt-out form — thereby increasing the ‘effort’ for not pledging their organs. It is no surprise that these countries have 99 per cent and 86 per cent organ donation rates, respectively, as opposed to 12 per cent in Germany and 17 per cent in the UK.

For equity instruments, a reasonably long-term lock-in may well serve as a useful default.

‘Lock-in’ prevents impulsive mistakes

Volatility in the stock markets affects investor’s minds. These behavioural hindrances to wealth creation can be dealt with if investors keep their emotions in check during market crashes. Investments in tax-saving schemes have a lock-in period of three years. This can prevent reactions caused by the fear induced through sharp corrections.

The year 2020 is a good case in point. The sharp correction led to an about ?25,000 crore redemption in equity mutual funds in March. Markets saw a V-shaped recovery from the bottom — the Nifty 50 bottomed out wiping out 35 per cent from the index and climbed back to scale all-time highs in December 2020. The default choice of three-year lock-in would have saved many an investor from the need to react.

An equally opposite behaviour of throwing caution to the wind is seen during euphoric bull-runs.

As they say, the most difficult thing in investing is ‘doing nothing’.

Two key concerns

Two valid critiques of ‘lock-in’ are: liquidity issues, and three years being a good enough time horizon.

1) Liquidity: Tax saving options with a higher lock-in period compared to ELSS include the National Saving Certificate, Senior Citizen Saving Scheme, bank FDs, unit linked insurance plans (all with 5-years lock-in), PPF (15 years lock-in) and the National Pension Scheme (lock-in until retirement)

If liquidity were of paramount importance to investors, then these tax saving options would have got far fewer allocations. We know for a fact that all the above mentioned options, barring NPS, have a far larger corpus compared to ELSS.

2) Is 3 years good enough: The best way to judge this would be to examine three-year rolling returns for all ELSS funds since the inception of this category (1996).The average three-year rolling return (calculated on a daily rolling basis) for all ELSS schemes is 14.85 per cent.

Also, there is no need to exit after completing three years. If you stick to your investments in ELSS and keep adding more to it each year, you are likely to make higher returns in the long term.

In the bestseller Sapiens — A Brief History of Humankind, Yoval Noah Harari explains how gossip helped us rule the world. Well, I believe the lock-in benefit in ELSS would be one thing worth gossiping about.

(The writer is Head-Products, Motilal Oswal AMC Ltd)

The article was originally published in Hindu on 23rd Dec, 2020

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