There is No Fate But What We Make: Personal Investment FAQs

Friday, October 21, 2005

Personal Investment FAQs

Disclaimer: I am not rich. Follow at your own risk.

I have received questions from friends and colleagues.
So I started writing this FAQ. Nothing is etched in stone.
So fine tune as you learn more. And as Suze Orman says,
"People first, then money, then things !"

1. Why should we invest for future ?
An important question. Since prices of things are rising,
doesn't it make sense to enjoy now rather than save
and consume later when we will get less for the same money ?
Yes, if we are going to keep money under the carpet.
No, if we are going to invest and the ROI is higher
than inflation rate. So if inflation is 5% and we
get 8% return, the money effectively grows 3%. So a
year later, we will enjoy more than what we would
enjoy if you spent now. This is the concept of "delayed gratification".
This is a unique characteristic of human beings.
No other animal has this. We are unique. There
would be NO progress and order in society without
this fundamental human attribute.

So why might we invest ?
To meet future goals that need money. Even if you
don't have a future goal (really ?),
you may want to build a buffer so you can sit out bad times.
If you are confident that you can manage to tide
through bad times, you don't need to invest.
Go ahead and enjoy now !
But for most people, investing is necessary.
Talking about bad times, when we are young we tend
to feel (naively) overconfident.
"What ? Laid off, me ?"
Well, I have seen smart people with perfect GPAs and
patents going through layoffs and bad times. Layoff
isn't a judgment on the people, it's just bad economic
cycles. Over a long term, economies go through cycles.
This is good for the overall economy of the world because
that's how chaff gets separated from the grain.
Or god forbid, a person is disabled and can't work.
Or falls ill and medical insurance won't pick up the
bills. Anything can happen. We can't control it.
But what we can do is to control our response. We can
do that by being prepared for the bad times.
We prepare by investing and creating wealth - also by
investing in self and relationships.

2. Okay, I want to invest. Where should I invest ?
When we went to see the Taj Mahal, did we show more interest
in the Taj Mahal or the way/vehicle we used to reach
there ? Similarly, we should focus on our goals more
than the instrument used for financing it.
"Where to invest" is secondary. "What for" is the
primary question. Over the long term, AAP is more
important than the choice of particular financial
instrument. See my post "Ten steps to wealth creation"
for more on AAP.
Read on for more questions where I talk about how
to select a financial instrument.

3. What is AAP that you keep harping about ?
Why is it important ?

AAP (Asset Allocation Plan or Asset Allocation Policy)
is a product of a lot of research
in Economics and applies to not only personal
finance but pretty much all aspects of
an enterprise (including nations). There are
tomes that discuss but this article should get us started.

In short, AAP has been proved to be the most important
factor in the success of long term investments.

4. Tell me the stock which I should buy and sell at
good profit.

Short answer - I don't know
Long answer - I don't know (do you see me vacationing in Honolulu ?).
In fact, no one knows because it is unknowable
due the very nature of the market. A stock is an asset
(it's a tiny piece of a company) whose fair value
depends on a host of factors. By the very nature of
capitalism, it is not possible to predict which stock
will go up and which will go down. Imagine, if anyone
knew that a business will fail, would he start/continue it ?
Anyone who is sure of a "hot pick" or a "listing gain"
doesn't know and doesn't know that he doesn't know.
This is not to say that there can't be a temporary
mispricing of stocks. But the window of opportunity
where a stock is overpriced or underpriced is short.
Day traders jump on any such oppurtunities and there by
correct the very mistake they were trying to exploit.
But here's the good news. You don't need to know for
sure which stock will go up and which will go down.
Just stick to a solid AAP and over the long term you
will reach your goals.

5. What is diversification ?
It's a fancy way of saying, "don't put all your eggs in the same basket."
Diversification, which is intricately related to AAP,
means you spread your bets. If you buy shares of one
company, it may go down for many reasons.
Even very good companies can falter (death of key
people/unexpected competition).
But if you have shares of 20 companies, it will hurt you less.
Yes, if you buy one share and that happens to be of
Infosys, you will beat the market and diversified
portfolios. But then what if you buy one company
and it happens to be Enron ?
It's all about managing risk. Diversification reduces
the risk of a wrong choice. Theoretically, you may
lose on returns due to diversification.
But a study of last 100 years of data shows that on
the long term, diversified portfolios beat overwhelming
majority of single stock selections.
The probability of our selecting that winning stock
is very very small. Do you want to fight such odds ?
Do you want to take that risk ? If you can afford lose
the principal, you may. But if this money is for kid's
education, it is a bad idea.
So instead of chasing one "hot stock", we need to have
a diversified portfolio and stick to our AAP for the long term.

Diversification means spreading your assets among:
Equity (shares, equity mutual funds),
Bonds (FDs, Post office deposits, RBI bonds,PPF, traditional LIC policies, Debt mutual funds)
Precious metals (Gold,Diamonds,Silver)
Real estate (home, office buildings, rentals, real estate mutual funds)
Cash (cash, Savings bank account balances, Liquid mutual funds)

There are other types like Arts (Picasso paintings)
and commodities (rice/oil/power etc) but these aren't
really for the average retail investors.

So our investment needs to be spread among these
asset classes. Within each asset class, there is a
need for diversification. Not all shares are alike.
Some companies are large, some are small, some are
turnaround candidates, some are asset rich.
Some bonds are high quality, meaning, there is no
chances of the debtor running away (like RBI bonds).
Then there are bonds for rogue companies which
promise very high interest and then run away
with the principal. These bonds are called junk bonds.

The best way to achieve within-class diversification
is to invest through mutual funds. This is the true purpose of
mutual funds - to provide in-class diversification.
Most mutual funds give much more, but this is the primary goal.

Unfortunately, there are no mutual funds in India
which invest in real estate, Art, commodities etc.
So if we want them in our portfolio, we have to do it ourselves.

6. What is Insurance ? Do I need it ?
Insurance is way of managing risk. If the breadwinner
of a family dies, there is a risk that the family will suffer from penury.
Or, an accident makes someone disabled and unable to
work, he will live in physical as well as financial misery.
While the emotional or physical losses can't be
compensated for, Insurance companies can compensate
for the financial loss.
We all should take insurance to manage these risks.
( Read the earlier part on naive overconfidence.
Bad things can happen to anyone. )
What can you insure against ?
- Death (a sum is paid in case of death of the
insured person so that the family can survive
and maintain their lifestyle)
- Accidental death (same as above but this is a
subset of the above since the death must be due
to an accident).
- Damage/Theft of expensive stuff (jewelry/electronic
items/Arts items at home (insurance company will
pay the market value of what you have lost)
- Vehicle (insurance company will pay the market value
of the vehicle of the make/model if lost.
Or the repair value.)
- Professional lawsuits (important for doctors, lawyers
or any service providers)

Do an objective analysis of what kind of insurance
you need. For example, if you are young and have no
financial dependents, do NOT take life insurance.
Even for young people with dependents, chances of
accidental death is much higher than natural death.
So if you really want a life cover, take accidental
death cover. Take disability cover in any case.

Never mix insurance with investments. Take pure term
cover for life insurance. Treat insurance as risk
protection and not as investment vehicle.
Ignore that insurance agent. He is NOT your friend.
He has a family to feed and wants his commission.
(If there are good agents who really advise clients
what's good for them, I haven't seen them yet.
Till then, the above stands)

7. Should I enter the market now ? Isn't Sensex/NAV at a too high level ?
It's impossible to time the market or "optimize"
our timings. Just invest regularly and stick to your AAP.
The odds are overwhelmingly favourable towards you
if you do so. Investment decisions should always be
taken based on your situation and your AAP.
Not based on where Sensex is.
Don't try to time the market. It's not the timing
but the length of time that matters. Invest
regularly, stay invested and stick to AAP.
Mutual Fund NAVs don't mean anything. Higher NAV
does NOT mean that the fund is expensive.

If you are not mathematically inclined, you can
ignore the rest of this answer.
Consider an amount invested (P) for t years getting an ROI of r.
The amount at the end of t years is, A = P * (1 + (r/100))^t
If you plot graphs of A vs. P and A vs. t, you will
see that the final amount varies directly with P but
geometrically with t.
This means that the initial investment amount is not
as important than the time you give to the investment.

Similarly, an amount (P) invested every year for t
years with ROI of r fetches you:

P * [ (1 + (r/100)) + (1 + (r/100))^1 + (1 + (r/100))^2 + ...
... (1 + (r/100))^(t-2) + (1 + (r/100))^(t-1) ]

Again, the investment amount (P) has less control on
the final amount. It's r and t that matter much more.
All those clamouring for salary hikes with their
employers are probably focusing on P. It's much more
financially rewarding to focus on r and t.


8. What are Mutual Funds ? Are they any good ?
A little bit of history. Christopher Columbus and
his motley crew went to a voyage and found a new land.
While Columbus took risk, the Portugese royal couple
also took risk by paying for the costs. But this
investment was wildly successful. Once trades started
and gold looted, unimaginable gains were made. The
ordinary rich folks (what an oxymoron !) also wanted
to do this. But they didn't have the reckless attitude
of the royal family. They were paying for the investment
from their own money. Not like the royal family who were
paying citizen's money. The royal family didn't
care about shipwrecks or pirates. But the regular investors did.
If someone pays for a ship's voyage and that ship sank,
his lifetime wealth sank (literally) ! This problem needed a creative solution.
The risk was mitigated by mutual funds. Investors pooled
in money and paid for voyages. So five people together
pooled in money and together paid for 5 voyages (with
20% share each). This is better than each one paying
for one voyage. Because in case of a wreck, that
investor went broke. At the cost of some returns
(probability of one out of five wrecking is higher
than one out of one), people could feel safer.

Today's mutual funds are similar. They pool money
from investors like you and me. They buy shares
of not one company but many companies.
For this, we pay a salary to the fund investor to
whom we delegate the task of judging, buying and
selling shares. The salary is charged as an "expense"
on the mutual fund. So note that mutual funds are not
free. Besides this salary, they have to pay for
marketing and broker commissions. All this comes
from our money. It's good to invest in mutual funds
because we can achieve diversification.
Suppose you have 10,000/- to invest. If you start
buying shares directly, you cannot achieve enough
diversification (unless you are buying penny stocks).
But with a mutual fund, you get instant diversification.

There are many types of mutual funds.
Equity funds - they invest in equity. Stick to
these. They are the best vehicle for equity investing
for most of us.
But there can be subtypes - Large cap funds who invest
in big companies Small cap/Mid cap etc. - you can guess.
Cap stands for "market capital" which is sort of an
indicator of how much a company is worth.
Market capital = share price * number of shares.
Sector funds - they invest in shares of a particular sector.
ELSS (Equity Linked Savings Scheme) funds - regular
equity fund but gives you tax breaks under 80C.

Debt funds - they invest in debt or bonds
(meaning, they give loans).
There are types based on bond duration. Some invest
in long term bonds. Some in short term bonds.
Some in very short term (like a day to a week) bonds.
These are called Cash or Liquid funds.
Then there are some funds which invest only in
Government bonds (called Gilt funds).
You can stay with general debt funds for your bond
part of the AAP.
For immediate requirement and for keeping emergency
money, use Liquid funds.

Real estate funds - they buy and trade in
houses and commercial property. Also they rent out
to get income. These funds (called REITs in USA) are
great for the real estate part of your AAP. Suppose I
have 1 lakh to invest and I would like to keep 20%
in real estate. But I can't buy a house for 20,000/-.
But these funds allow me to do it.
Unfortunately there are no such funds in India yet.
So regular Joes like me can't invest in real estate
in this way.

Commodities funds - they trade in "things"
like cereals/metals. Advanced countries even have
funds trading in "weather". Go figure that out !!
Again, no luck in India yet. You have to be a guru
or a farmer if you want to make money out of
rice price cycles.

Index Funds
These funds invest in the same stocks in the same proportion
as the Index they track. For example, Franklin India Index Fund
is an Index fund that tracks Nifty. This means that it will
buy same stocks in the same proportion as there are in Nifty.
There is no judgment to be made. Computer programs can be
written that blindly mirror the Nifty. Hence expenses are less.
There is no need for a fund manager.
In advanced markets, it is believed that Index funds beat
actively managed funds over the long term.
I am not yet convinced that this is true for India as well.

Balanced Funds - These invest in a combination of asset classes.
Most common are the funds that invest in a mix of equity and debt.

After looking at all pros and cons, Mutual funds
in some form or other, are the best way to invest
for most of us.

The equity part of your AAP can be in
shares directly or in equity funds. Unless the
portfolio size is more than 2 lakhs, stick to
mutual funds, no matter how lucrative and surefire
that "IPO listing gain" appears.
It's hard not to give in. Specially, when all your
friends are gloating over gains and the media hypes
up everything. But this is what can be the difference
between retiring peacefully at 40 and enjoying life
or, having to work till you are 62 !


9. Boy, I am confused about all Mutual Funds.
How do I pick a mutual fund ? Which option is good ?

If you believe in AAP theory, you will know that asset
class is much more important than the exact investment
vehicle. Meaning, the fact that you are 60% in equity
is more important than whether that 60% is in
Franklin Prima Fund or HDFC Equity Fund.

Having said that, here's what I look for in
mutual funds.

Expenses - lower the better - this is the "fee"
you are paying the fund manager. All fund account
statement will give the expense as a percentage of
the total fund value (called "Expense Ratio").
There are laws which put a higher limit to the
expense ratios. For equity fund, it is 2.5%.
Most actual expense rations are around 2.3%.
But then there are exceptions. Watch for too much
transactions (buy/selling) by a fund. This usually
means higher expense ratio. Look for loads. Lesser
the load, better for the investor.

Fund size - too large is bad as they can't enter
in small companies. Too small is bad because they
can't diversify enough. Also smaller funds
will have higher expense ratio since the fixed
costs need to be spread over smaller fund size.

Philosophy - each fund states what the investment
pattern will be like. What % in shares, what % in
cash etc. How frequently it will trade (buy/sell)
shares. Check if the fund sticks to this stated
philosophy.

Diversification - Unless a fund has stated to be
a sector fund, it should be well diversified across
sectors. There were many funds which had upto 60%
in IT sector back in 2000. You know what happened
to them, right ?

Performance - while looking for performance,
look for consistency of performance with respect
to the benchmark. Don't compare a sector fund
performance with a regular equity fund. And don't
compare equity fund performance with a debt fund.
The fund you choose should be among the top
third in its peers over an extended period of time.
Past performance doesn't mean future performance.
But if the same fund has achieved a good
relative performance over a long term, I will tend
to pick it (provided other factors stated above are
OK). Don't have unrealistic expectations. If the
general market tanked 30%, even the best fund will
go down. This is when to remind yourself that you
invested in equity for the long term.

Note that I have listed the performance as the last parameter.
For two reasons - (i) as I have already stated elsewhere - performance of your portfolio is controlled more by asset allocation than the exact selection of investment vehicle (ii) Past performance is no guarantee of future performance. As Graham said, long term results of two different diversified and representative list will not vary much. Neither has any advantage over the other. Long term returns of instruments of the same asset class revert to the mean. So focus on picking a mutual fund based on the earlier parameters rather than performance alone.


Now about options. Each fund has further options -
growth, dividend, dividend reinvestment etc.
Earlier, these were important due to tax
considerations. But not any longer. Stick to
"Growth" option unless you have invested for
the purpose of regular income.

Watch for conflict of interest. Most mutual fund
agents push those funds that give them highest
commission. See how aggressively they push new
funds (they give them highest commissions). Do not let
agents advise you on which fund to buy.
Agents are not your friends.



10. What about taxes ?
It's very important that your investments are
tax friendly. Tax deferred growth beats taxed
growth by a mile ! Minimize your taxes.
Long term equity capital gains are now tax free.
If you are a follower of AAP, all your equity
investments are for more than a year. So even
the government is telling you to follow AAP and
avoid short term trading.
Real estate gains are taxed at lower rates if
the property has been held for more than
three years.
While bank interest is taxed at regular
slab rates, Mutual fund gains are taxed at
lower rates. This is why I would advocate
mutual funds to just about everyone.

11. What about investment expenses ?
Taxes are the biggest expense usually. But
watch out for loads in mutual funds, any fee
you pay to your investment advisor, subscription
to investment magazines, demat account charges.
If you are investing one lakh a year and you are
paying 5000/- as a fee to your "advisor" you are
effectively paying 5% entry load. The probability
of this portfolio beating a well diversified AAP -
compliant portfolio over the long term is almost nil.

12. Should I invest in IPOs ?
We human beings are irrational. If any proof is
required, we just have to study the IPO phenomenon.
What is an IPO ? It's when company insiders
sell shares to general public. Who knows more about
the company ? The company insiders or us ? Whom will
the price be favourable to - insiders or us ?
A lot of hype is made of the "listing gain".
Unless you are a trader (then you are in the
wrong blog), this gain means nothing to you.
What you need to see is long term returns.
Studies have shown that investment return from
IPOs will lag the general market returns by more
than 5% over the long term.
I am not saying you should completely ignore IPOs.
They can be good opportunities too.
Here's how an AAP compliant investor will look at
IPOs. Let's say you want to put 60% in equity.
Out of which 10% you would like to mid cap stocks.
Let's say this translates to 10,000/-. So you now
look for all the mid cap companies in the market
(and the IPOs happening around that time, if any).
Which is the most investment worthy ?
Let's say you are looking to invest in the Energy sector.
You should will ask myself, which company is the best for
investment in this sector today ?
If it is the one that is having the IPO, go ahead
and invest in it. But now you know why you are
investing in it. Blindly investing in IPOs wishing
for some magical "listing gains" is foolish.
You will ride your luck for a while. But sooner or
later you will burn your fingers.

13. Should I invest in Mutual Fund IPOs
(new fund offers) ? Isn't an NAV of 10 cheap ?

Short answer - No
Long answer - since you wouldn't invest in a fund
without seeing its track record for a long term,
how can you invest in a new fund ?
Do yourself a favour. Ignore that agent who peddles
the new fund. Read my earlier "Mutual Fund - 1" for
more on this.

14. What about futures and options ? What about Technical analysis ?
Warren Buffet calls futures and options financial WMDs
(Weapons of Mass Destruction). Read his articles on
this topic. If you are an ardent believer of these,
go ahead and invest. I don't find it worthwhile to invest
in them.

Technical Analysis ? The black art with which traders
can "predict" short term movements of a stock. Well,
short term stock price movements are random. No amount
of analysis and mining can find any pattern on something
that is mathematically "random". I don't believe one
can make a living by trading based on technical analysis.

15. Is this particular product XYZ good ?
This is the most asked question ! It is asked in various ways -
"Is PPF any good ?" "Is ICICI LifeTime plan good ?"
"Is HSBC Equity fund better than DSP Super SIP ?"
"Should I apply for Suzlon Energy IPO ?"
"When is the last day for Tata Contra Fund IPO ?"

As an AAP believer, you will know that these questions are much less
important than your distribution of investment across asset classes.
Still these are the questions you will hear being asked most often.
These questions are based on a false premise -
that a product is good or bad in absolute terms.
The real question to ask is -
"Is this particular product XYZ good for me at this point of time ?"
BioGene Inc may be a great stock for me today to park the bonus that
I received. But will I recommend it to my mother who is a pensioner ? Hell, no !
All financial products of the same asset class are based on the same principles.
So the real question to ask is whether the
product fits your financial plan. Again go back
to your AAP and decide what kind of products
(asset class) you will invest in.

Still, I will give my views on certain specific
products. I am not in a position in offer advice
on specific stocks as I am no good at it.
Besides, it isn't that important on the long term.

PPF
This is for the bonds part of your AAP for long
term goals. Government backed, investment gives
tax breaks, tax deferred growth, tax free gains.
Can't be attached by court. Can you ask for more ?
Enjoy while Government keeps the interest artificially high.

Life Insurance Policies
(Money Back, Endowment, WholeLife, ULIP)
Stay away. Do not mix investment and insurance.
They serve different needs. The "convenience" of
getting it all in a single product is costly.
Stick to term life insurance. For investment,
look for pure investment products.
For the super rich who want to pass on wealth
without inheritance tax, "WholeLife" is good.
I haven't seen any ULIP policy which can
beat mutual funds in terms of flexibility and
expenses. So they are no good for most people.
"Premium back" insurance policies - stay away.
It gets negative marks for misleading customers.

Debt Funds
Good in general. But because of artificially
high interests in post office products,
they score better. Tax treatment of these vary.
So decision will be specific for the individual.

Equity funds
A big resounding YES.
Diversified equity funds should be the core of
your long term investments.

Individual Stocks
Yes, if you portfolio is large enough so that
expenses are low and you can have adequate diversification.

Real estate
For self use - YES
For investment, wait till real estate mutual funds start in India.
Otherwise, if you have 1 crore to invest, you can
buy that 10 lakh land in Electronic city just for
investment. But taking a second loan to invest in
real estate ? And this land cost is more
than 10% of your total worth ? You are kidding, right ?

Gold/Precious metals
Upto 10% of your total networth. Preferably as bars
(yes, you can buy Gold bars certified for purity).
Precious metal is a good hedge against war times
and calamities. But most Indians buy way too much
gold as Jewellery. This is not good because
(a) it is more than 10% of the networth and hence
they are missing out on higher returns from other asset classes
(b) there are making charges and wastages in ornamental jewellery.

Commodities / Arts
Stay away unless you are a guru or a farmer.
Ditto for Arts. Don't dabble unless you can tell
Raphael from Van Gogh. But if there are mutual funds
for these, consider upto 10% of networth.

16. Does "know thyself" have any relevance to investment ?
Your best friend, and worst enemy, is not the market, not the stars,
but yourself.
Benjamin Graham's classic "Intelligent Investor" has done such a
superb job of explaining this. Read that book before you make your
first investment. After reading, spend a month introspecting.
Try to understand yourself.
You have no control on the market or the SENSEX. But you can and
should control your behaviour.
Here are some of his gems to whet your apetite:
1. "An investment operation is one which, upon thorough analysis
promises safety of principal and an adequate return. Operations
not meeting these requirements are speculative."
Please take the effort to really understand this. Each of the
terms used are defined in his book. All of us tend to think of
ourselves as long term investors.
Chances are, people will accept being shop lifters but not see
themselves as speculators. But with the light of the above rule
by Graham, was your IPO investment in that "hot" company not a
speculation ?
Not that speculation is evil per se. But let's not delude
ourselves that we are investing when we are speculating.
Apply Graham's rule ruthlessly.
2. Emotion is yout worst enemy when it comes to investment.
3. Inactivity and laziness won't make you look cool or popular.
Nor is it advised in general. But when it comes to investment,
inactivity is your best friend.
4. Know what is reasoable to expect from various asset classes.
5. Know the impact of inflation.
6. Know history. The basic tenets of the capitalist system have
not changed since the times of Isaac Newton. Newton could
calculate positions and movements of heavenly bodies but
could never figure out why stock prices are so irrational.
Nothing has changed since then even though we have gone
through tunip bulb craze of 17th century, great depression,
airline stock craze of 1940s, world wars, 1987 crash,
internet and technology craze and subsequent fall.
Those who don't learn from history, repeat it. If this is
true anywhere, it is in the area of investment.
7. Long term wealth is created by lack of trading (activity)
and a balanced portfolio that is in sync with your goals
and temperament. You don't need to get a Microsoft or
Infosys to create wealth.
8. A stock is not a ticker symbol. The stock price charts
are useless. Focus on the business behind.
9. Know how to calculate the worth of a company. And growth
prospects. But this information alone is not enough to make
an investment decision. You need to see the price you are
paying for the stock. Even a great business with a great
growth oppurtunities may not be worth investing into if
the price is too high. Even a so so company with so so growth
prospects may be worth investing into if the price
is low enough. Look for margin of safety in every investment.
10. Even though we need to be "intelligent" investors, this
intelligence doesn't have to do anything with the brain.
Isaac Newton or the Economics Nobel winners who ran LTCM fund
were more than intelligent. Yet they didn't have the character
traits that make it possible to create wealth over the long term.
Do you ?

17. My dad says stocks are risky. Are they ?
Your dad is right. Stocks are indeed risky. This is the truth. However, the complete truth is that there is a risk in everything – including NOT investing in stocks. There are various kinds of risks. It’s good to categorize them. There is the risk of principal loss. There is the risk of losing the purchasing power due to prices going up. While stocks can expose you to the former risk, not holding stocks exposes you to the latter risk. Just focusing on one type of risk is not correct. Since there are various types of risk, a balance needs to be arrived at by looking at your financial goals, your appetite for and ability to tolerate various kinds of risks.
Remember there is a risk of dieing in an accident on the road. But there is also a risk of dieing due to house collapse of one chooses to live indoors. The correct thing to do is trying to minimize the risks. AAP, diversification etc. are the tools to minimize financial risks.

18. What about pension plans ? Is that PruICICI pension plan any good ?
From a financial perspective, "retirement" is just another goal which is
no different from, say, "buy a large car two years later". Once you retire, you need
to live off your investments. There won't be a monthly salary. So you need to generate income out of money invested. To explain, if you have 100 Lakhs invested in
a bank at 7% interest, you will make 7 lakhs a year (pre tax). You have to live on
that. But things are more complex than this. Due to inflation, 7 lakhs will be not
give you the same lifestyle that you enjoy today. Also interest rates can change. If it goes down and you have inflation, it will hurt from both sides ! Then there are taxes ! You may have to part with one third of what you earn as taxes. Here's a more realistic calculation which takes into account inflation and taxes.
Suppose you want to retire in 20 years and at current price levels, you need 6 lakhs rupees a year to live on. Considering a 7% inflation, you will need 23 Lakhs a year 20 years from now to maintain the same lifestyle. Surprised ? Well, that's inflation power ! Inflation is the evil twin sister of compound interest. While the latter can make you a crorepati at 40, the former can reduce the value of that crore. If you need 23 lakhs a year, you need to generate at least that much every year. Actually you need more considering that inflation will be there even after you retire. So at 10th year after retirement, you will need ((1.07)**10) X 23 = 46 lakhs a year. If you are laughing at these numbers, you will be in serious trouble. Because this is the kind of income you will need just to maintain current lifestyle. Now, to the important question of how to plan for retirement, convert it all to numbers. Considering that inflation will stay forever (worstcase scenario), you cannot spend all the income you generate. In addition, you can't afford to pay taxes any more that what you absolutely have to. Which means that you can't withdraw full 7% interest that you may earn. Experts have come to an agreement that a 3% withdrawl rate can sustain someone's life without the risk of erosion of capital while handling inflation. So if 3% of R is 23 lakhs, R = 773 lakhs. With this amount of retirement capital, you are reasonably sure that your principal won't go away and you can live off income. Bank interests are not very tax friendly. So you will have to invest a good part in income funds (mutual funds that invest in bonds). Since capital gains tax rates are lower, bulk of money needs to be here after retirement.
Now we need to see the other side of the game. How to get that 773 lakhs ? Use the good sister - compound interest ! Invest in equity and you can get there. You may have to play aound with the number of years to retire to reach the correct figure. But you can't do anything but invest in equity for long term goals like retirement. Forget PPF, traditional LIC policies (either from state owned LIC or private ones like PruICICI). A lot of insurance companies sell policies as "pension plans". Just because they are called "pension plans", doesn't mean that they are the best way to prepare for retirement. If they don't invest in equity, just ignore them. If they do, see expenses etc, just as you would judge a mutual fund. They usually club some life cover. If you are not looking for life cover, that part of the premium which goes for life cover is a waste. Looking at many factors, one is better off investing in mutual funds even for retirement. I ignore these "pension plans" including those which are marketed as ULIPs. If i need life cover, i just buy term cover. So get cracking, use your calculator and start investing !

4 Comments:

At Monday, February 20, 2006 3:24:00 AM, Anonymous Mohan C Nair said...

Hey Charu, I have never seen such detailed suggesstion, information on investment. THis is sure gonna chnage my perspective on my investment. Knowingly or unknowingly i was making mistakes in taking ULIPS, Investing only in NFO leavning the best performing MFs and scores of other "Do Not Do" things that you have written in your article. I am just feeling lucky to have read yor article. I am spreading the same to all my colleagues so that they too can benefit from this. I would like to know how do i get notified on the future articles published by you?. I am new to blogging and blank about the concept.

Thanks & Warm Regards

MOHAN
mohan_gates@yahoo.com

 
At Monday, February 20, 2006 6:56:00 PM, Blogger Charu Majumdar said...

i am not surprised that you were into
ULIPs and NFOs.. these give the maximum commission to agents and hence
they keep trying to sell these...
About notification, there is something
called "RSS" in this blog that can be
used to get notifications. i have
never used it though..

 
At Tuesday, February 28, 2006 3:24:00 AM, Anonymous Mohan C Nair said...

Hello Charu,

Can you explain what does hedging means? The recent NFO of Reliance Equity Fund boasts of this feature.

MOHAN
mohan_gates@yahoo.com

 
At Tuesday, February 28, 2006 4:14:00 AM, Blogger Charu Majumdar said...

http://en.wikipedia.org/wiki/Hedging
this should help...

 

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