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Business News/ Money / Calculators/  4 things to calculate before counting your money
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4 things to calculate before counting your money

When you invest, several factors can diminish the magic of compounding, such as commissions and taxes. So, don't jump at the first investment opportunity that offers great returns, look deeper

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Are your financial goals on track? You may have a budget in place to generate the required savings and an investment plan to make the money work for you. But there are still situations that may be out of your hands to influence. However, what you can do is to make sure that you are not missing out on some of the obvious steps that can ring fence your financial plan as far as possible.

The success of your financial plan depends on how well you define your goals and how efficiently you select the investment vehicles to make your money work for you. Here are some of the factors and numbers relating to your investments, which you can ignore only at the risk of falling short of your financial goals.

Don’t ignore the effect of inflation. It steadily eats into the value of your money and pushes up the amount of funds required to meet an expense in the future.

If inflation is assumed at 6%, then the cost of paying for your child’s education, which perhaps costs Rs4 lakh a year today, would be double that amount in 12 years.

While 6% may not seem like a large number at first, its effect compounds over the years—especially in case of long-term goals. Longer the period to the goal, greater will be its impact. If the effect of inflation is not considered while defining financial goals, then the value that is being targeted for them will be completely off the mark. The net result would be a corpus that is much lower than what you would actually need to meet the goals in the future.

Apart from looking at the general inflation rate, also consider the observed increase in cost of particular goals. For example, costs related to education and health, typically, increase at a much faster rate than those for general expenses.

Costs and fees eat into the returns from your investment. Don’t consider only the out-of pocket expenses that you have to pay—such as commissions and brokerages. Also consider the hidden costs that are ultimately charged to your investment.

These include expenses that are charged to the investment before its value is declared, such as fluctuating net asset values of mutual fund schemes and deductions from the gross amount invested to account for commissions.

When you evaluate investments, look beyond the return numbers. These costs can be found across products, so compare the products on these parameters too before deciding about them. If the costs are higher compared to other similar investments, then see if the higher costs are justified in any way. For example, actively managed equity funds charge a higher expense ration as compared to index funds. This is justified only if the actively managed fund consistently performs better than the index funds in rising and falling markets.

In the periods when returns are good, the higher expenses and deductions may not be seen as significant by the investor. But the same expenses levels will hurt when the returns fall or there are losses.

Consider all the costs involved in making and managing and investments, irrespective how they are charged or paid. All these affect the final corpus value that is available to you to meet the goals.

The returns that you consider while evaluating investments are typically the pre-tax returns. A 10% return on a company fixed deposit may look good, but if you are in the 30% tax bracket, the effective return you earn would be only about 7%.

When you look at an investment through a post-tax lens, the suitability may be very different. Higher the tax bracket of the investor, greater will be the gap between the pre- and post-tax returns. From the point of view of an investor’s goals, the relevant number is the post-tax return.

It is important therefore to be aware of how the returns from various investments will be taxed. Look for ways in which you can maximize your post-tax returns.

For example, investing in debt securities through a debt mutual fund may be more tax-efficient than directly holding the bonds, where the interest income earned will be taxed according to the investor’s tax bracket.

Where the option is available, choose to draw returns as periodic dividend or interest income, or as capital gain, depending on which option gives your the best post-tax returns.

Don’t ignore the risks while evaluating an investment for its suitability for your goals. The investor must be willing to trade-off higher risk for higher returns. The impact of higher risk of volatility, default or illiquidity should be considered in light of the goal.

An investor may be willing to take on some volatility and illiquidity for a longer-term goal but not for a medium- or short-term goal.

Don’t ignore the performance of comparable investment options. Very often, the decision matrix considers the historic return performance of the investment under consideration, and maybe the risk factors. But it is important to consider how the benchmark and comparable investments performed, to determine the investment’s relative performance.

If you don’t do this, then you may be condemning your savings to working less efficiently for you. Compare apples to apples, to make sure that you have the right information. It is not enough if your investment is earning a level of return that you consider to be acceptable for your needs.

You need an investment that is consistently outperforming the benchmark and is a top-quartile performer in comparable investments, both in appreciating and declining markets.

The effects of compounding will be lower to the extent that the return numbers are lower as a result of performance, taxes and costs. Make sure you have considered all the relevant numbers to safeguard your savings and investments.

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Published: 28 Mar 2017, 04:33 PM IST
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