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Don’t go by the figures, peel off the return sticker

Don’t go by the figures, peel off the return sticker
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First Published: Mon, Mar 29 2010. 11 41 PM IST

Updated: Mon, Mar 29 2010. 11 41 PM IST
So you make news around the office coffee table when you announce that you have found a product that will give you 100% return. Till the quiet guy across the room gently pricks the bubble of hope. The 100% return was actually a smart sales push—over the 10-year investment period—this works out to just 7% a year. Yes, Rs1 lakh becomes Rs2 lakh. But in eight years seven months, even the staid Kisan Vikas Patra will do the same.
The advertisement is good to lure non-investors, but for smarter investors, actual return matters. So, what is it that you get in hand in terms of what that money can buy? Says Veer Sardesai, chief executive, Sardesai Finance, a Pune-based financial planning firm: “The advertised return should be per annum and should be compounded. From this rate of return, deduct your tax liability and inflation. If, after this, the return on your investment is negative, the investment is not worthwhile unless you want to just protect the money and are ready to sacrifice return.”
Cost, inflation, tax and compounding are four key things that can melt a fat looking return figure into nothing. Here are five questions to ask before you swallow any sales push that is using returns to make the pitch.
Also See How much you really get (Graphic)
Is it annual?
What an investment will throw off each year is the relevant number and not what the corpus will grow to. Sellers use the big fat final corpus numbers to lure investors, like in the case of the 100% advertisement. The 100% return winds down to a mere 7% per year. Remember to benchmark an annual return to a comparative fixed deposit (FD) return or the 8% on government schemes for long-term products.
Simple or compounded?
Simple interest is when the amount you invest, say Rs1 lakh, yields a return that is not added back to the principal, but usually paid out, like in a fixed deposit. Compound interest will add back the interest to the principal and calculate the interest due for the next year on the combined amount of the principal and interest. And this it will do repeatedly, over the life of the investment. Simple interest of 10% on Rs1 lakh over 10 years will give a final corpus of Rs2 lakh and compound interest will give Rs2.59 lakh.
Is it post-cost?
A rate of return is the rate at which your money grows, it does not reflect the corpus that you get at the end of the term. Apart from fixed-return investment vehicles such as the Public Provident Fund (PPF), actively managed investment avenues such as mutual funds (MFs) charge you for managing your money. MFs cap charges at 2.5%, unit-linked insurance plans with tenors over 10 years cap it at 2.25%. Deduct the charges and you get the actual yield on your investment.
Is it post-tax?
Taxes eat up a substantial part of your return. So, taxable instruments, such as FDs, are not so popular with savvy investors. An attractive 9% FD may lose its sheen after you pay 30% tax on the interest and find that your net return is just 6%.
What after inflation?
The silent purchasing power killer is more difficult to build in since it is money that goes to nobody directly but value we lose to inflation. An 8% return means a real return of just 2% if inflation is at 6%.
What should you do?
What happens when we build in all these costs into one product? A FD that pays 8% turns into a negative return of -0.4% if we build in tax at the rate of 30% and inflation at 6%. A 15% MF return, after 2% cost and 6% inflation, comes down to 4.5%. Advises Pallav Sinha, managing director and CEO, Fullerton Securities India, an investment firm: “It is important that you break the headline return into net return which you get in hand.” So, watch out for the return shavers as they silently remove layers from that fat number in the sales pitch.
Graphic by Yogesh Kumar/Mint
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First Published: Mon, Mar 29 2010. 11 41 PM IST
More Topics: Investment | Tax | Insurance | Inflation | Investor |