BackHow much does it cost? Learning to ask this in finance
When it comes to an investment, we get so focused on returns that we disregard the cost
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We ask this question all the time when we’re shopping. Whether it is the veggie or fruit vendor or the kirana store, kitne ka hai? (how much does it cost?) is the most heard phrase in a shop. Go to a mall, and barring the super cool, super rich, everybody else is busy struggling to find the price tag on the shoe or piece of clothing on display. Displays are all geared to get your attention to a good deal. And in shopping, a good deal is one that has a discount, costs less or you get something free with it.
How come we never think about costs when we buy financial products? When it comes to an investment, we get so focused on what returns we will get, and whether it is “safe", that we disregard a key part of the deal—the cost. Any investment will have several costs associated with the product—there will be cost of entry, an ongoing cost, a cost to exit, then there are costs of taxation and a cost imposed by inflation. The goal of any investment is to get returns that protect purchasing power at the minimum—that is to say that 100 invested today should return at least 100 in purchasing power terms after five years. So the return has to beat costs, taxation and inflation. But, let’s stay with the first three—what a product actually costs you to buy, keep and sell.
What different products cost is a function of regulatory cost caps and industry standard practices. For example, although mutual funds were allowed to charge up to 7% entry load before 2009, the industry standard was 2.5% that was deducted from investors’ investment towards distribution cost. Regulatory caps are important for they set what is akin to the maximum retail price that we face when we buy consumer goods. As investors in financial products, we’ve learnt to at least ask about some of the costs of entry into a product, but I find it particularly amazing how the costs of real estate are ignored when it is considered as an investment destination. The conversation is always about what one paid for the property and what it’s worth now. But there is no discussion on costs. For instance, what did it cost to buy it in terms of brokerage and stamp duty? What about building in the cost of the loan that is usually taken? A 10% interest on a 1 crore loan for 20 years will make the property cost you over 2.31 crore. At 11%, it costs you 2.47 crore. At 12%, it is 2.64 crore. Then there is the cost of doing up the house for either living in it or renting it out. This can vary from a few thousand rupees to several lakhs. Now count the ongoing maintenance costs of the building. The older the building, the more it costs to fix leaking pipes, walls and so on. Build in property tax. And now look at what it has cost you to buy that house and what the value is today. Price in the capital gains tax that you have to pay if you sell to realize your investment. Of course, one of the issues in real estate is that more than half the value of the property is in cash, hence avoiding the taxes at different points of the transaction.
While as investors we gloss over costs in real estate, the insurance sector makes hiding costs an art. These are sold using lump sum numbers—1 lakh each year for 10 years will grow to 20 lakh in 15 years. Your brain registers “money double" but does not ask “what did it cost me?" An annual return in the deal above is 6.7% return. Public Provident Fund gives you about 8%. The difference between an 8% and a 6.7% return is your cost.
Finance has often used smoke and mirrors to hide costs of financial products from regulators and investors. A good regulator is one who can stuff all costs into one bucket and then make that number very public. This does two things. One, companies are unable to push costs in things that are hidden away from the investor. Two, it allows third-party analysts and comparison sites to compare products easily. Notice, that I have not said it allows investors to compare products. I don’t say it, because asking an average investor to compare costs is not unlike telling a car buyer to ensure that the car is safe by looking under the bonnet. As an investor, if you are not able to get a straight answer to the question “what does it cost?", walk away.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com
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