Five concepts you need to understand while investing

Five concepts you need to understand while investing
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First Published: Tue, May 19 2009. 10 42 PM IST

Updated: Tue, May 19 2009. 10 42 PM IST
No, this is not about what this column expects the new government to do for financial sector reform. It is assuming that these are going to be fast-tracked, and along with new products and services, consumers of financial products will bear the burden of too much choice.
In his book The Paradox Of Choice, sociology professor Barry Schwartz links excessive choice to consumer misery. He shows how too many similar-looking options actually cause consumers to freeze and prefer status quo to taking any proactive decision. While in the US the number of mutual fund schemes outnumber listed stocks, India is getting there with at least 1,500 funds and investment-linked insurance plans. This number is set to balloon in the next five years as more firms line up at the Indian doorway to get a piece of the vast Indian financial products market.
To pre-empt the frozen-in-the-floodlight-of-choice effect, here are five concepts that you need to understand and use to evaluate financial products before you buy.
First, understand the difference between real and nominal rates of return. When I buy strawberries from Khan Market in New Delhi, I get the guy to flip the box out on a sheet of paper. Sure enough, the bottom of the box has a padding of newspaper an inch thick, reducing my strawberries by one layer. I used to pay for the whole box and realized that I got fewer strawberries due to the newspaper padding.
Look at rates of return that financial products carry in the same way, with the rate of inflation taking the place of newspaper padding. If a one-year fixed deposit (FD) is offering a 9% interest rate, try and find the projected inflation rate for the next year and see what you have left after inflation has reduced your purchasing power then. If inflation is going to be 12%, you are losing by buying that FD.
A safe product such as an FD needs to promise at least 2-3 percentage points over the inflation rate to make investing sense. Remember, the long-term inflation trend line in India is 5-6%.
Second, understand what the product costs you to buy, maintain and sell. Every financial product has a cost embedded into it and we need to unravel the costs from the projected returns to see what the product is actually worth. For example, a mutual fund that projects an average annual rate of return of 10% will actually return just 7.74% due to the standard front and ongoing costs.
It is similar for insurance-linked investment products. It is not easy for a retail investor to unravel these costs, and till some regulations come into being in this area, it is best to ask your agent or bank to tell you the post-cost return figure. For an estimated return of, say, 10%, choose the product that, other things being similar, throws off the highest post-cost return.
Third, what is the tax impact? The return needs to be reduced by the amount of tax that you will end up paying on the interest or capital gain that the product earns you. Today, a one-year FD carrying 8%, with inflation projected at 4% next year for a 33% tax-bracket person, will actually earn 2.58%. And that is pretty good. Most years, the gap between FD returns and inflation is just about 1 percentage point, leaving little on the table after taxes.
Fourth, the difference between present and future value. While some products are sold on the basis of the potential return rate, some are sold with absolute numbers that can be expected after some years. The sales pitch of your money doubling in 10 years, or an investment of Rs35,000 today becoming Rs1 lakh after 20 years, sounds great. But remember we are comparing two absolute numbers.
In the interim 20 years, the value of the rupee will get a haircut and the present value of that Rs1 lakh today will be just Rs31,000, less than what you have put in. The relevant number in any financial decision is the expected rate of return and not the absolute money back in rupees. For products that guarantee returns, just knowing the absolute number at the end of a time period is not enough; you need to know the rate of return. In the above example, the two rates of return are 7.2% and 5.4%.
Which brings us to the fifth tool, benchmarks. In 2007, when market-linked products were being sold, I often got calls from agents hawking products that had returned 25% in the last three years. Sounded good, till one examined the market index to find that the index itself had grown more than that in those years. Which means that had I bought an index fund instead of the fund being sold, I’d have done better than the managed fund—that carries more cost than an index fund.
Benchmarks in financial products are essential because these products are invisible and their good or bad attributes will only face you after many years, by which time it is too late. In the absence of standardized guidelines across regulators on benchmarks, you need to get your adviser to put the comparison between the relevant benchmark index and the product he is offering in writing, before you buy.
Monika Halan is a certified financial planner and is currently working as adviser, Pension Fund Regulatory and Development Authority. Your comments and personal finance queries are welcome at expenseaccount@livemint.com
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First Published: Tue, May 19 2009. 10 42 PM IST