How Psychology plays an important Role in your Financial Decisions?

Till now I have written many articles on different topics of personal finance but this is my first article on “How Psychology plays an important role in your financial decisions?”

When I say Psychology plays important role in your financial decisions, it looks very odd at first instance. Apparently it looks that finance has nothing to do with psychology but let me tell you that your psychology plays a very important role in your success as an investor. Let us see this in detail.

How Investor Returns different from Investment Returns?

I have been in financial advisory practice since last twelve years now, and have observed that equity markets are giving good returns since long but investors are not able to earn that much returns. For example, Sensex which is index of 30 Large cap companies of India was started somewhere in April-1979 with a base of 100 and today it is more than 26000. So it shows that if someone had invested one lakh in Sensex in 1979 then his one lakh has become more than two crores and sixty lakhs in a period of around 37 years. Here returns are more than 15% compounded annualized. But when I look at investors I hardly find any investor who  could earn 15% p.a. kind of compounded returns in their portfolio over such long periods. So why investors are not able earn this kind of returns. Simple reason for this is our mistakes.

This picture shows this very clearly. Investment returns are much higher but investor returns are on lower side. So investments have given returns but investors have failed to gain those returns and this is due to behavioral gap. Investors behave in a manner that affects their returns negatively. In this regard conventional finance theory says that investors are rational and they act in a rational manner while taking their investment decision. Whereas Behavioral finance theory which has been developed off late in last two to three decades says that investors are emotional and they act in an emotional way while taking decisions related to their investments.

Left Brain v/s Right Brain Theory:

Now the question is why investors act emotionally and not rationally while making their investment decisions. There are different theories to this, one very famous and universally known theory is Right Brain : Left Brain theory which says that there are two sides of our brain, left and right. Left brain is more logical, rational, analytical brain which processes numbers, logic,etc., Whereas, Right brain is more emotional, subjective, creative and acts in an intuitive manner. People who are left brain oriented are logical and take rational decision where as people who are right brain oriented are emotional and behave emotionally. But my experience says that people generally use left brain in their own profession or business and use right brain in rest of the areas in life, Let me take an example of a doctor suppose a doctor gets a call from a patient says that his son his suffering from fever and has stomach pain and asks him to give some medicine then what would doctor do? Doctor will not prescribe a medicine on phone he will ask him to bring the patient to hospital and will recommend the medicine only after proper diagnosis. But suppose for the same doctor if one of his best friends, who is also a doctor but keeps reading magazines on finance suggest him to buy shares of a company very strongly what will he do. Mostly doctor will buy those shares. So when he had to take decision in his own profession where his core competence lies he prefers to do detailed analysis but in financial decisions he is ready to rely on a person who is not a professional and don’t want to even see whether he has done proper research or not. He is using left brain in his own profession and right brain in other areas of life. Same happens with everyone, we use left brain in our profession and right brain in other areas of life.

Fast Thinking v/s Slow Thinking System in our Brain:

The second theory is given by Daniel Kahneman, a psychologist and Noble price winner in Economics who said that our brain has two systems, first is system -1 Fast Thinking System  which thinks very fast, intuitive, emotional, subconscious and acts on a snap assessment of situation very quickly. Second is system-2 Slow Thinking System which is slow, rational, logical and reacts to situation slowly after detailed analysis of the situation. Let us see with illustration. If I ask you that 2+2 is how much you will immediately say 4. If I ask you 4+4 you will say 8. But if I ask you 6X9X7X18= then you will stop thinking and make calculations. So when you answered first two questions you used system 1 which is a fast thinking and answered the questions immediately but when the third question came your system 1 could not answer that and the question was sent to system 2 that is slow thinking system for calculation and detailed analysis. Let me ask you one more question here. There is one combo offer in a shop where one chocolate is available with a small candy in total of Rs. 11. There is no discount and price of chocolate is 10 Rs. more than price of candy. Now question is what is the price of Candy? Most of you will say that it is Rs. 1 but think quietly. If price of candy is Rs. 1 then and price of chocolate is Rs. 10 more than price of candy then price of chocolate will become Rs. 11 and total will become Rs.12. But total price is Rs. 11 only. So price of candy is Rs. 0.50. Now think why most of people at first instance give answer that candy’s price as Rs. 1? Because they use System -1 which is fast thinking system because question looks very simple so they don’t do detailed analysis and do snap assessment. This is what happens in real life while taking financial decisions because they look very simple but they are not so simple.

System 1 is the Fast thinking system of the brain which works on emotions, intuitions and snap assessment of the situation and answers questions very fast. System 1 has its uses in the daily life. Suppose you are driving a car and suddenly a truck comes on your way what will you do? Simply you will trigger the break and stop the car. So here you actually did not do any analysis it happens on it’s own. Here system 1 which is fast thinking part of the brain works and stops the car. So system 1 which is fast thinking is a survival system. It helps us to survive because if in above example you use system 2 and do detailed analysis then by that time you will meet an accident.

Both system 1- Fast thinking and system 2- Slow thinking are not opposite to each other, they are complementary to each other and both are important for us. But sometimes we use system 1 – Fast thinking system at places where we should use system 2, and that leads us to wrong conclusions.

While taking investment decisions we make the same mistake we do a basic, intuitive analysis and take decisions based on that analysis so questions which look very simple like above case of chocolate and candy are actually complex and need detailed analysis.

In my next article I will be discussing some psychological biases which affect our decision making process in investments.

 

Currency Demonetization & its Implications

3Currency demonetization, suddenly this word hits us on the evening of 8th of November, 2016 and we all were shocked with the demonetization measure of Prime Minister Shri Narendra Modi. This article is an effort to understand What Currency demonetization is actually and what will be its Short term & long term Economic implications.

To understand currency demonetization we first need to understand that any currency holds its value as a valid currency of that country due to two basic characteristics, which are as under.

  • Currency is a legal tender by the Govt. of that country to use it as a medium of exchange to fulfil your financial obligation.
  • Currency is a promissory note by Reserve Bank of India. It holds a promise to pay the equivalent amount by the RBI Governor.

In his speech of 8th Nov. 2016, our Prime Minister Shri Narendra Modi declared that from midnight of 8th Nov. 2016, all the currency notes of 500 & 1000 will not be a legal tender. So it lost its value as a medium of exchange in the country but RBI’s promise to pay the equivalent money remains intact till 30th Dec. 2016(after that it will remain valid a some places till 31st March 2017.), if you deposit that money in your bank account or get it exchanged in a bank.

Why demonetization of 500 & 1000 Currency notes was needed?

Total value of currency printed by RBI in India is around 16.4 Lakh Crores Rs. as mentioned with break up in table below. 500 & 1000 Rs. Currency notes in total comes to around 14.2 Lakhs crores which is around 86% of total Indian currency. So cancellation of 86% currency will definitely cause serious liquidity issue in the economy which is more cash driven.

table50

Over last few years demand for currency (hard cash) was increasing in our country. Ideally in a country like India where economy is growing with a reasonably good pace, and banking system is also growing with good pace, demand for currency should reduce. Net fresh issuance of currency notes have increased by 34% in FY15 and 46% in FY16. This raises a possibility of large currency leakages – Money going out of the system (e.g. hoarding of black money or outside India, both are illegal.) It seems that due to tightening of KYC norms, tax laws and monitoring of other financial transaction in different investment avenues like post office, Mutual funds, banks and real estate etc., the black money which was invested earlier in these avenues was now preserved in the form of Cash in high denomination currency notes.

Currency is actually a medium of exchange but when it is preserved and kept in lockers it becomes a commodity to hold black money. This has a serious implication in the economy as this result to poor liquidity in the banking system.

So, Demonetization of 500 & 1000 currency notes is a step to curb black money.Now let us see how big this Black economy is in India?

There are no reliable estimates of black economy. A survey conducted by World Bank in 2007 says that around 23.2% of GDP is running as a black economy. So if we go with these numbers then our GDP is estimated to be 200 Lakhs crores this year and the 23.2 % of this would be around 46.4 Lakhs crores. Avg. Tax incidence in India is 16% so if we tax this 46.4 Lakh crores at 16% then the tax collection would be around 7.42 lakh crores. Our fiscal deficit for next year is estimated to be somewhere close to 7 lakh crores so if we convert this black economy to white we will have no fiscal deficit.

But the question is whether this step of demonetization will lead us to 100% conversion of black economy to white economy. The answer is certainly NO. But it can definitely push 30% to 40% conversion from black economy to white economy.

Consequences of Black Money:

Black money affects not only our economy but also our Social system. Social implications and economic implications of black money are interrelated and have cascading impact on each other. Let us see both the implications in detail.

  • Impact to Economy: When people start holding cash to preserve black money, the circulation of currency is affected very badly. When currency changes hands it turns to income and expense of many people which helps people to satisfy their needs and creates job opportunities for people. Since last few years increasing cash holding in the country resulted to poor liquidity in the banks which made our banking system weaker. Banking system is back born of an economy and a weak banking system with poor liquidity cannot support a fast economic growth.
  • Social implications: There are many social implications of black money. Increasing black money widens the gap between poor and rich which leads to social unrest. Black money also increases corruption and crime. Use of black money in elections by different parties is not anew thing in this country. Currently four state have their elections in March-2017. All these problems make our economy weak and it again creates social imbalance in the country so this is a vicious cycle and has a cascading effect.

How demonetization will help?

As discussed earlier 500 & 1000. Currency notes have lost their value as a legal tender from 8th Nov. 2016, midnight. But, RBI Governor’s promise to pay equivalent amount against these currency notes is still valid, but for that one has to deposit the currency notes to their bank account or get it exchanged from banks. So we are left out with two options as shown in below table.

chart50

Option 1: Deposit back the 500 & 1000 Currency notes with bank: People who have cash on hand in 500 & 1000 Currency notes which is accounted and tax paid money will deposit it back. A prediction says that around 10.62 lakh crores will come back with in the banking system. This will improve liquidity in our banking system which in turn will help us to strengthen our Economy.

Option 2: Don’t Deposit back in Bank: Those who have black money in the form of 500 & 1000. Currency notes will not be able to deposit it in the bank. A rough estimate says that around 4 Lakhs crores will not come back to banking system. So, on these currency notes, which will not return back to Reserve Bank of India, RBI’s liability to pay back will be over so this will result to profits to RBI and Govt. Now RBI can print new currency of equivalent amount and Govt. Can increase its expenditure towards infrastructure and other areas to spend this money. This will lead to increase in the income of people which ultimately will boost the economy.

Impact on different sectors: Different sectors will have different long term and short term impact of currency demonetization which is as under.

  • Interest Rates: Due to this action by Govt., Interest rates will fall sharply in short term and will also remain at low over medium to long term. This will bring down fixed deposit rates. Along with that loan interest rates will also fall sharply.
  • Inflation: over next 3 to 6 months demonetization will create deflationary pressure which will result to very low inflation in the country. Over medium to long term there will be neutral impact on inflation.
  • Real Estate: Over short term real estate prices can fall sharply. Real estate where there is no cash portion in the price will have relatively less impact. Over long term, if interest rates fall sharply and stay at low level this can have positive impact on real estate.
  • Equity Market: Due to currency crisis, consumption will fall and this will affect corporate results for next one or two quarters. So equity markets will also remain volatile till that time and are expected to fall sharply. But over long term it seems that we are entering in a new bull market cycle.
  • Gold Prices : Gold prices will not be affected much as they are internationally drive but demand for gold particularly against cash will fall sharply over short term.

To conclude with, this step will cause some pain over short term to common man but over a long term this may lead to a new beginning to the country and common man will be the beneficiary.

All about Section 80C of Income Tax Act.

pic2Sec 80C of income tax is most popular section for Small & middle tax payers. Deduction is available only to Individual tax payer and HUF. Deduction available u/s 80C is Rs. 1, 50,000/- from Financial year 2014-15 (before it was Rs. 1, 00,000/-) to all assessees, means if Assessee is in  30% tax bracket  than He/She can save Rs. 45000/- tax (30% of 1,50,000).

Let us discuss deductions in brief.

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Life Insurance Premium

In case of Individual –

Individual can claim deduction for life insurance premium paid for himself, spouse and children (dependent or independent) but deduction not available for Premium paid for parent’s life insurance policy. If individual has more than one life insurance policy than deduction available to aggregate of all premium paid. It is not necessary to have the insurance policy from Life Insurance Corporation (LIC) – even insurance bought from private players can be considered here.

In case of HUF-

Individual can claim deduction for life insurance premium paid for members.

Provident Fund & Voluntary Provident Fund

Amount deducted from salary and deposited in Provident fund by employer (in case of salaried person) than it is considered to be investment and it is deductible u/s 80C .

Assessee has option to contribute additional amount through Voluntary provident fund and it is also considered as investment and deductible u/s 80C.

Public Provident Fund

In case of Individual-

Assessee can claim deduction of Amount deposited in PPF A/C of himself, wife and children’s (dependent &independent). PPF interest is exempt from tax and maturity amount is also exempt from tax so it is one of good investment scheme.

In case of HUF-

HUF can claim deduction of Amount deposited if PPF A/c of members.

5 Year Fixed Deposit & 5 Year Post office time deposit

Tax saving fixed deposit and post office time deposit of 5 year tenure is liable for deduction u/s 80C but interest earned on it is fully taxable. There are special fixed deposits in the bank which have maturity period of 5 years and are eligible for deduction under section 80C. Similarly Post offices also have a  5 year time deposit scheme which is also eligible for deduction under section 80C.

National Savings Certificate (NSC) (VIII Issue): 

NSC is a time-tested tax saving instrument with a maturity period of five Years. Presently, the interest is paid @ 8.10% p.a. on 5 year NSC.

Premature withdrawals are permitted only in specific circumstances such as death of the holder. Investments in NSC are eligible for a deduction of up to Rs 150,000 p.a. under Section 80C. Furthermore, the accrued interest which is deemed to be reinvested qualifies for deduction under Section 80C. However, the interest income is chargeable to tax in the year in which it accrues.

Stamp Duty and Registration Charges for a home:

This is not much known by the tax payers that the amount you pay as stamp duty when you buy a house and the amount you pay for the registration of the documents of the house can be claimed as deduction under section 80C in the year of purchase of the house.

Repayment of Housing loan Principal:

Deduction is available of Repayment of Principal Amount (not interest amount) of Home loan taken from specified financial institutions or entities like your employer a public limited company, central government or state government or board, corporation, university established by law. However in respect of loans taken from your relatives though you can claim deduction under Sec

tion 24b for interest, the deduction under Section 80 C for repayment is not available.

Deduction is available from Assesse has taken possession of property and if property sold within 5 year of possession than deduction claimed in earlier years is taxable in the year of property sold.

First time home buyers will get additional exemption of upto Rs. 50,000/- on interest paid for loans upto Rs. 35 lakhs with cost of home upto Rs. 50 lakhs but property should be purchased between 01/04/2016 to 31/03/2017 and loan to be sanctioned during this period only.

Infrastructure Bonds:

These are also popularly called Infra Bonds. These are issued by infrastructure companies, and not the government. The amount that you invest in these bonds can also be included in Sec 80C deductions.

Pension Funds – Section 80CCC :

This section – Sec 80CCC – stipulates that an investment in pension funds is eligible for deduction from your income. Section 80CCC investment limit is clubbed with the limit of Section 80C – it means that the total deduction available for 80CCC and 80C is Rs. 1.50 Lakh. This also means that your investment in pension funds up to Rs. 1.50 Lakh can be claimed as deduction u/s 80CCC. However, as mentioned earlier, the total deduction u/s 80C and 80CCC cannot exceed Rs. 1.50 Lakh.

Senior Citizen Savings Scheme 2004 (SCSS):

Amount deposited in SCSS is deductible u/s 80 C. The account may be opened by an individual, who has attained age of 60 years or above on the date of opening of the account. & who has attained the age 55 years or more but less than 60 years and has retired under a Voluntary Retirement Scheme or a Special Voluntary Retirement Scheme on the date of opening of the account within three months from the date of retirement. & No age limit for the retired personnel of Defense services provided they fulfill other specified conditions.

Education Expense:

Assessee can claim deduction of Tuition fees paid for Children’s education purpose (restricted to only 2 children’s) but educational institute must be in India and deduction is available for tuition fees only. So any amount paid as development charges, library charges are not deductible. Here tuition fees don’t mean that fees of private tuition classes.

Sukanya Samiriddhi Account:

Sukanya Samiriddhi Scheme Launched by Prime Minister Shri Narendra Modi on 22 January 2015 for a girl child. Any amount deposited in the Sukanya Samiriddhi Account is deductible u/s 80C. Interest earned on account is Tax free and Amount received at the time of maturity if also tax free. Interest rate is 9.1% for FY 2014-15 ,9.2% for FY 2015-16 and 8.6% for 2016-17. Minimum amount can be deposited in one year is Rs.1000/- and maximum amount can be deposited is Rs. 1,50,000/-.

Equity Linked Saving Scheme (ELSS):

ELSS of Mutual Funds are more popular since they are giving good returns in long run and lock in period is just 3 years which is shortest lock in period in saving based investment u/s 80C. In case of investment done by SIP than each SIP installment is treated as separate investment for lock in period purpose.

To conclude with section 80C is a very comprehensive section which offers deduction of Rs. 150000 in total for all above investments or expenses from income directly. Tax payers should understand all these investments and expenses and plan their finances accordingly to take full advantage of this section.

Saving Money vs. Investing Money : What is the difference?

Most of the times people think that savings and investment are same and use these two words as synonyms of each other. But actually savings and investment are two different concepts and we need to realize this. Even many of the financé websites also confuse savings with investments. Many times we also give messages to our children like” penny saved is penny earned”, “ Savings of today is assurance of tomorrow” etc. so while communicating we use the word savings. But savings has a limited meaning whereas investment is much broader concept in itself. This article is an effort to clarify the difference between the two so that all of you can exactly understand this and then check whether you are good saver or good investor?

What is savings? & how it is different from Investment?

Savings is basically the difference between your income and all type of cash outflows like your monthly expenses, EMIs, taxes etc. . See below formula.                               

 Income – (Expenses + EMIs+ Taxes) = Savings.

So from above formula it is clear that money that is saved after paying of all expenses, liabilities and taxes is saving. Now you may park it in saving account, fixed deposits or liquid funds on a temporary basis. But this money doesn’t start earning good returns until you apply it towards effective investment instruments as per your financial goals.

So there the difference of savings and investment starts. Actually there is very thin line between savings and investment. Savings is the money which is actually left out after paying all your expenses, taxes and liabilities and you have kept aside. But it becomes investment when you allocate it for your financial goals and invest in instruments like shares, bonds etc. with clear investment horizon and strategy to generate better returns. Money which is saved should be invested to meet your Short Term, Medium Term or Long Term Goals. Following are few important differences between Savings and Investment.

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How much should you save? & How to improve your savings rate?

Your savings have direct impact on your wealth creation. But the question is how much should you save from your income?  Some people say that you should save 30% some say 50%. But actually there is no such standard for how much should be saved from income.  At initial stage of your career when your income is low you may not be able to save more. But as your income grows and your basic expenses are met with, your savings rate should improve.

To improve savings rate one should focus upon budgeting.Once you focus upon budgeting and then writing actual expenses, you can compare them with budgeted expenses under different heads and mark out the deviation. If actual expenses under any head are more than budgeted, you can analyze why they are higher than budgeted. This will help you in controlling your expenses and improve your savings rate.

To conclude with investment and savings are different and a part of your savings should be invested for long term goals and wealth creation. Generally Indians are good savers but poor investors. So it is important to become a good investor than a good saver because investments will create wealth for you and not savings.

 

How to fight with inflation?

pic-46nAs discussed in my earlier post “Inflation: Biggest Enemy in your Financial Life.Inflation is one of the most signifacant risk to once fiancial life, now the question is how to fight with it?

First of all investors need to recognize the impact of inflation on their long term goals. Most of the times while planning for their financial goals investors either don’t consider inflation or try to consider it in ad hoc manner which is wrong. When you consider 8% inflation it is compounded 8% p.a. and not simple so your cost will double almost in every 9 years. It has a very slow but significant impact on our Financial Goals. Below chart will show you the value of goal increases at 8% inflation over the years.table-1-46

Now let us discuss some important aspects of investing to fight with the inflation.

Start Early: Most importantly to fight with the inflation, you have to start saving for goals as early as possible. More you delay, more it will be difficult for you to achieve that goal. Let us take an example of education goal discussed in my last post. 

table2-46

From above chart it is clearly evident that goal value reaches to 74 lacs from 20 lacs in a period of 17 years. Now let us see how much investment is required at 10% returns on investment to achieve the goal of Rs. 74 lacs if we start investing from now, delay the investment for 5 years (Start the investment for the goal when child is 6 years old) or delay the investment for 10 years (start the investment when the child is 11 years old).

table3-46

In above table in option A the investor selects to save for the goals from now. So he needs to invest Rs. 1.83 lacs every year for next 17 years and total investment required is Rs.31.02 lacs. Whereas if he starts after 5 years( as shown in Option B) he will have to save for 12 year only but annual investment required to achieve value of Rs. 74 lacs will be 3.46 lacs and total investment required is 41.52 lacs . So delay of 5 years increases the total investment required by around 10.50 lacs (41.52-31.02) which around 33% more than Option A when investment for the goal is started immediately. In C investment  starts 10 years late as compared to A and so the annual investment required is 7.80 lacs and total investment required to achieve the goal is 54.60 lacs which is 23 lacs (76%) higher as compared to option A . So the earlier you start better you will be to beat inflation.

Try to Earn High Real Returns : Indian investors are traditionally fond of investing in fixed deposits and gold. Typically returns in these asset classes range between 7% to 9% p.a. and inflation in different goals is also somewhat similar to returns so they end up earning very low real returns.

If you are investing Rs. 100 in 8% fixed deposit and inflation is also 8% then after one year you will get Rs. 108 from your fixed deposit and due to inflation goods or services which you are able to buy today with Rs.100 will also be available for Rs. 108 so actually you have just maintained value of money and not earned any returns.

Let us once again take example of education goal discussed above. To achieve education goal of Rs. 74 lacs after 17 years if investment is started right now, Let us see how much investment is required if rate of return on investment made is 8%, 10% and 12%.

table 4-46ne

As shown in above chart, at 12% Rate of Return annual investment required is 1.51 lacs and total investment required is 25.73 lacs where as at 10% Rate of Return annual investment required is Rs.1.82 and total investment required to achieve goal is 31.02 lacs. So at 10% Rate of Return on investment , total investment required increases by 5.29 lacs which is 21% higher as compared to investment done at 12% Rate of Return. Similarly in case of investment done at 8% returns annual investment required is Rs. 2.19 lacs and total investment required to achieve the goal is 37.27 lacs. So at 8% Rate of Return one has to invest Rs. 11.53 lacs more to achieve education goal as compared to investment to be done at 12% Rate of Return.

Now, you may have a question that how to achieve 10% or 12% Rate of Returns. So for your long term goals inflation is the most significant risk and to beat it you should be investing a part of your investment in asset classes like equity which can give you higher returns and then rebalance your portfolio between equity and debt. IF you have investment horizon of more than 5 years then a significant part of your total investment should be invested in Equity oriented Mutual Fund. Please do remember that for deciding how much should be invested in equity? and how it should be rebalanced? You should take the help of a qualified financial planner.

Equity as an asset class contains risk of volatility but it helps you to beat inflation and for your long term goals you should take risk of volatility and not inflation. For Financial goals which are short term you should not take risk of volatility. Most of the time investors don’t consider inflation as a risk, which is a big mistake that they do.

To conclude with, to fight with inflation you have to earn high real returns and start investing as early as possible.

 

Inflation: Biggest Enemy in your Financial Life.

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Inflation is one of the biggest enemies in our financial life but most of the times I find that investors forget to consider impact of inflation on their financial lives. In this article I will try to explain “what is inflation?” from micro economic perspective and then we will see what is impact of inflation on our life?

What is Inflation?

As a general definition “Inflation is a continuous rise in the prices of commodities, goods and services.” This means that when prices of any goods, commodities or services keep increasing on a continuous basis that is inflation. But actually it is other way round, prices of commodities does not increase but value of currency keeps falling and that’s why its purchasing power also falls so what a 100 rupee currency note could buy a year ago, it cannot buy the same goods and services today. So there is fall in the value of rupee or purchasing power of rupee has fallen. There are many reasons for this but one primary reason for this is when the government prints new currency and puts in the economy by spending it on infrastructure, rising salaries etc. the value of existing currency falls. This happens because same commodities are chased by more currency.  So Inflation is basically fall in the purchasing power of Rupee and not the rise in the price of the commodities.

How it affects your financial life?

The biggest mistake layman investors make is, they forget to consider impact of inflation on their financial life. Inflation has a severe impact on our long term goals like Retirement, Education Cost of our children etc. Let me explain you with few real life case studies to bring more clarity.

Recently, a client approached me for his financial planning. He had just retired from senior management of a very good company.

Following are his facts and figures.

table1

This gentleman had saved in PPF and EPF for entire life except for some small life insurance policies. When I met him He was of the view that he has around 80 lacs corpus which is sufficient to survive. He told me that he will receive around 8% interest in fixed deposit which will come to

Rs. 640000 ( 8% * 8000000). His monthly expenses including all type of expenses are Rs. 40000 so annually he needs Rs. 480000/- and his interest income will be Rs. 640000 so he will save around Rs. 160000(640000-480000). In this case if I assume 8% p.a. inflation in his cost of living let us see How his annual cost of living increases over next 10 years.

For convenience we have assumed zero taxes and 8% interest rates. PPF corpus of Rs. 10 lacs is kept for meeting any medical emergencies and hence not taken into account in calculations.

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table3

chart

Look in above table, in fifth year (2019) his cost of living is more than his interest income. Please note that he is not increasing his lifestyle, he is just maintaining his life style and from 2019 onwards if he wants to maintain same lifestyle, he will have to withdraw from his basic capital Rs. 80 lacs.

Mistake this gentleman made is he did not consider impact of inflation on his cost of living. Similarly let us see some other life goals how they are affected by inflation.

How inflation affects your Children’s education goals?

Last month a couple came to me to plan higher education cost of their one year old son. He estimated that his son will need Rs.20 lacs to go abroad to get higher education in a good engineering college when he reaches age of 17 years so wanted to invest from now. He wanted to invest Rs. 5 lacs now and believed that it will become Rs. 20 lacs when his son reaches 18 years. But this Rs. 20 lacs was today’s value of that education cost. When I asked about inflation on that cost he was blank and had no answer. Following table will show the inflation adjusted value of Rs. 20 lacs after 17 years.

table4

The value of Rs. 20 lacs becomes Rs. 74 lacs after 17 years. So goal which was looking easy to achieve now looks very difficult.

When I made above calculation and showed him that inflation adjusted value of Rs. 20 Lacs will be around 74 lacs they were first shocked and argued that there is some mistake in calculation. Afterwards they accepted this calculation.

So inflation is our biggest enemy in completing our long term goals. But major issue is that while planning our future goals like Retirement, Education fund for our children etc. we don’t take into consideration inflation. Either we consider same level of expenses in long term or we don’t calculate their future values putting inflation percentage properly. This way inflation is the biggest risk to our long term goals but it has very low affect on our short term goals. Suppose a goal is only one year away from now then the inflation will not affect if much but for long term goals inflation is the biggest risk.

In my next article I will be writing on “How to fight with inflation?” and that will be in continuation to this article based on case studies discussed above.

Good Debt v/s Bad Debt:How to understand the difference?

Most of us have taken Loans in our lives for one or other objectives but When I speak with people on whether one should borrow or not and whether debt is good or bad, I find that most of people are on either extremes, some believe that one should always borrow money for their needs whereas others believe that as far as possible one should not borrow and live within his means. Both these approaches are not correct all the times. One should try to bring a balance in his approach towards using borrowed money.  Whether the debt is good or bad depends on many factors like the objective of debt, tax benefits on interest etc and cannot be determined on the basis on any one factor. Also there is no single answer that can be applied to everyone. The answer of this question changes from person to person and situation to situation. This article is an effort to bring clarity when a debt can be considered good and when it can be considered bad.

Borrowed money comes at additional cost: First of all we need to understand one thing that borrowed money comes at cost. When you borrow money you have to repay along with interest. This interest increases the cost of asset or objective for which it was borrowed.

When you borrow you consume your future income in present: Another point that you should understand is when you borrow and consume it for any purpose, you have to repay along with interest cost in future. So here you are consuming your future income in present.

Debt can be considered good or bad on following aspects.

debt new1When it is taken to buy an Asset: Money can be borrowed to buy an asset. In such a situation it can be further classified in Appreciating Assets and Depreciating assets. Let us understand both the cases.

Appreciating Assets: Appreciating assets are the assets, the value of which will appreciate over a period of time. When loan is taken to buy any kind of property like home, land etc these are the assets for which value will generally appreciate. Please remember that in these assets also value can go down but mostly value will appreciate.  Now such properties can be bought for self consumption like for residential purpose, business purpose or they can be bought for just investment purpose. Here I have given below my conclusion on both.

Properties for self consumption: When an asset is bought for self consumption like residential property or premises to run business the Debt (Loan) created to buy that property is good or bad should not be measured on appreciation of the property because it is for self consumption. Such property is taken for self consumption and that is why it is a good debt. But one should keep in mind that he is not over spending on that asset with borrowed money. For example if I need a 3 BHK flat and I buy a 5 BHK and spend a lot on decorating it with the borrowed money than it is not a good debt. This is because this type of property is bought for self consumption so how much it appreciates is not important but when you overspend on it, you have to pay significant cost for that borrowed money.

Properties bought for investment Purpose: When an appreciating asset like land, house etc are bought for investment purpose with borrowed money, it is good debt if it fetches you more post tax returns than post tax interest that you pay for the same. What I mean to say is that when you borrow money to buy a property for investment purpose, you are basically investing in real estate with borrowed capital so you have to earn more than your interest cost. While calculating your interest cost, you also have to consider tax benefit earned on that interest. So you have to give net effect of interest and similarly while calculating market value or sales value of your assets you have to consider tax to be paid on that.  

If you are able to generate more post tax returns then it is a good debt otherwise it is not a good debt. But the problem here is it is difficult to guess returns at the time of buying such investment assets with borrowed capital. So in such a case you should be very conservative while taking such buying decisions. You should try to buy such assets at low valuations as far as possible.

Depreciating Assets: It is general belief that loans taken to buy depreciating assets are not good debts but this belief is not a true belief all the times. If a depreciating asset is bought to increase your working efficiency then it is a good debt. For example if you are buying a car or instruments for hospital with borrowed money, they are depreciating assets but they are going  to increase your efficiency so it is not a bad debt.

 In such case debt is bad when it is taken for depreciating assets which are luxury assets like if you need a car and you can easily do with a basic car which may cost you Rs.5 to 8 lakhs but you buy a luxury car of Rs. 15 lakhs then money borrowed for such luxury car is a Bad Debt according to me because here you are enjoying luxury at borrowed money.

Consumer Loans: Consumer loans are loans which are taken mostly for personal or family use. Like loans taken for buying small items of home use or travelling etc. ideally these loans increase your overall expenditure so they are not Good Debt but still if you get it at a lower or zero interest they are Good Debt.

Why should I borrow if I have my own resources to buy Appreciating assets, depreciating assets or consumer durables?

A question that comes from many readers is that why should I borrow for appreciating assets, depreciating assets or for consumer durables if I have my own resources. The answer is if you can earn more post tax returns on your own money than interest that you have to pay while borrowing that money than logically you should borrow rather than spending your own money. But while calculating interest to be paid please consider post tax interest if you are getting any tax advantage on that. Most of the investors forget to give tax impact on this.

Most of the people become emotional on this and believe that Debt is always bad and should use their own money when they have but this is not a rational decision so I would suggest you to use borrowed money in such cases.

Good Debt or Bad Deb is a Relative matter than Absolute: whether your Debt is good or Bad is a relative matter and cannot be judged absolutely on few factors. By relative I want to say that it is customized to once own circumstances like whether he gets tax benefit or not, he can earn better returns on his own money when he takes loan for something rather than investing his own money or not, so never try to take this decision just on the basis of a single factor that whether you are borrowing for appreciating asset or not, or whether you will get tax benefit on interest or not.

To conclude with borrowed capital is always at a cost so be very careful and calculative while using it and never take decisions on one or two factors alone.

Legal Structure of Mutual Funds in India.

PIC-41newIn my last article “ All about Mutual Funds. Advantages & Disadvantages of Mutual funds”,I had discussed about basics as well as advantages and disadvantages of Mutual funds. Mutual Funds are very strong and stable vehicle for investing in different asset classes. Most of the investors whether they are investing in Mutual Funds or not, are not very clear about the Legal structure of Mutual Funds in India. This article is an effort to educate investors about the legal structure and functioning of Mutual funds in India. Practically as an investor understanding legal structure of the Mutual Funds will not add much value to your financial life but most of the investors consider Mutual funds as unsafe investments and have lots of misunderstanding about legal structure of Mutual funds, this article will clarify those misunderstandings and will make you understand how safe your money is with Mutual Funds.

Legal Structure of Mutual Funds:

Now we will see what is legal structure of Mutual Funds? & how Mutual fund companies are formed?

Who Regulates Mutual funds?

  • Mutual Funds are regulated by the Securities & Exchange Board of India in India. SEBI has formed “SEBI MF Regulations 1996” to regulate functioning of Mutual Funds.
  • Under this regulation Mutual Funds are formed as Public Trust under “The Indian Trust Act, 1882”.
  • These regulations stipulate a three tired structure of entities – sponsor (creation), trustees, and Asset Management Company (fund management) – for carrying out different functions of a mutual fund, but place the primary responsibility on the trustees.

Who is Mutual Fund sponsor? & What are Roles & Responsibilities of Sponsor?

Mutual fund sponsor is basically promoter of the Mutual Fund Company. Sponsor either on his own or in association with another body corporate establishes a Mutual to earn money from fund management through its subsidiary company which acts as Investment Manager of the Fund.

Sponsors then,

  • Set up a Public Trust under “The Indian Trust Act, 1882”, and appoint trustees to manage the trust. Gets trust registered with SEBI and also takes all the necessary approvals from the SEBI.
  • Create an Asset Management Company under “The Companies Act, 1956”.
  • As sponsor is the main entity promoting a mutual fund company and mutual funds are going to manage public money, SEBI has kept very strict guidelines for the eligibility of the Sponsor.

Registration of Trust & Appointment of Trustees:

  • Creation of Trust: Sponsors create trust through trust deed in the favour of trustees. Trustees manage the trust and they are primarily responsible to investors in Mutual Funds. They are primarily guardians of Unit Holder’s money.
  • Appointment of Trustees: Sponsor with prior approval of SEBI appoints trustees. There should be at least four members in the board of trustees with at least 2/3rd independent. A trustee of one mutual fund cannot be trustee of another mutual fund, unless he is an independent trustee in both cases and has the approval of both the boards. The trustees are appointed by executing and registering a trust deed under the provisions of “Indian Registration Act”. This trust deed is also registered with SEBI.
  • Responsibilities of Trustees: Primary responsibility of Trustees is to see that all the due diligence is done properly and all the regulations are properly followed. All schemes floated by the AMC have to be approved by the trustees. Trustees review and ensure that the net worth of the AMC is as per the regulatory norms. They have to furnish SEBI a report on the activities of AMC on half yearly basis.
  • Trustees also enter in an agreement with the Asset Management Company.
  • Trustees can obtain necessary information from the Asset Management Company. All the schemes have to be approved from Trustee before they are launched.
  • Trustees have to appoint all key personnel like Fund Managers, Auditors, Custodian, Registrar, Compliance Officer etc. and to inform the SEBI about same.

Asset Management Company: Trust will appoint Asset Management Company as Investment Managers through an agreement called “Investment Management Agreement”.

  • Sponsor creates Asset Management Company and Asset Management Company manages funds of the Trust and against that it charges small fee. The AMC structures various schemes, launches the scheme and mobilizes initial amount, manages the funds and give services to the investors.

Sponsor, Trust and Asset Management Company are the Three Tir system which runs entire Mutual fund Business. Following are some other important entities involved in the functioning of a Mutual Fund.

Custodian: In Mutual funds , Asset Management Company buys different securities in the forms of Shares, bonds, gold etc. in different schemes. These Securities are bought in the name of Trust but they are not kept with the Trust. The responsibility of safe keeping the securities is on the custodian. Securities, which are in material form, are kept in safe custody of a custodian and securities, which are in “De-Materialized” form, are kept with a Depository participant, who acts on the advice of custodian. Custodian performs a very important back office operation. They ensure that delivery has been taken of the securities, which are bought, and that they are transferred in the name of the mutual fund. They also ensure that funds are paid out when securities are bought. Custodian keeps the investment account of the mutual fund. They collect and account for the dividends and interest receivables on mutual fund investments. They also keep track of various corporate actions like bonus issue, rights issue, and stock split; buy back offers, open offer etc and act on these as per instructions of the Investment manager.

Registrar & Transfer Agent: Registrar and Transfer agent is a separate entity. Registrar & Transfer agent has a responsibility of performing many administrative jobs like processing of applications of investors, creating units when new investment is made, removing units when investors made redemptions, keeping full record of investors, processing dividend payout. Mutual fund investors are spread across the country to small cities and towns so it is not possible to provide these services to investors at all these places by Asset Management Company. Registrar & Transfer Agents have their offices spread to these different locations and they work for many Mutual Funds to perform these jobs. So it becomes possible to provide services to unit holders at different locations in a very cost effective manner.

Auditor: Asset Management Companies are required to maintain separate books of accounts for all the schemes and prepare separate Annual reports for all schemes. An Auditor’s role is to examine books of accounts and annual report of all the schemes as an independent auditor. Asset Management Companies are also required to maintain their books of accounts and get the audit done under The Companies Act, 1956. As per rules separate auditors are appointed for Asset Management Company and Schemes.

Brokers: Brokers are registered members of the stock exchange whose services are utilized by AMCs to buy and sells securities on the stock exchanges. Many brokers also provide the Investment Manager (AMC) with research reports on the performance of various companies, sector and market outlook, investment recommendations etc.

Conclusion: From above discussion, it is clear that mutual funds are well regulated by SEBI. SEBI has formed three tired structure between sponsor, Trustee and Asset Management Company to ensure safety of investor’s money. Different agencies are involved in the functioning of the Mutual funds, like custodian is responsible for safe keeping of securities, transfer agent is responsible for creation of units and other services, Auditors verify that accounting is done properly as per regulations. Brokers are members of stock exchanges who provide services of buying and selling of securities. Trustees are responsible to take care of unit holder’s interest and reporting to SEBI. So the entire functioning doesn’t remain with Asset Management Company or Sponsors.

All about Mutual Funds. Advantages & Disadvantages of Mutual Funds.

pic40Mutual Fund is a common pool of money, where large number of investors, invest their money and then that money is invested in stocks, bonds, gold, money market instruments and other types of securities. So Mutual fund is not an asset class in itself like equity, debt or gold but it is a means to invest in different asset classes.

The ownership of the fund is thus joint or “mutual”; the fund belongs to all investors. A single investor’s ownership of the fund is in the same proportion as the amount of the contribution made by him or her bears to the total amount of the fund.

Legal structure of Mutual Funds is that of trust, which accepts savings from investors and invest the same in diversified financial instruments in terms of objectives set out in the trusts deed with the view to reduce the risk and maximize the income and capital appreciation for distribution for the members. A Mutual Fund is a corporation and the fund manager’s interest is to professionally manage the funds provided by the investors and provide a return on them after deducting reasonable management fees.Following chart summarizes advantages and disadvantages of Mutual Funds,Which are explained below.

table40

Let us see advantages of Mutual fund:

1) Portfolio Diversification: As discussed above, Mutual fund is a common pool of money. So when a large number of investors invest their money in a Mutual Fund Scheme, they become joint owners of this scheme and then that scheme will invest in to number of securities as per the objective of the scheme. Mutual funds help investors to get diversified at two levels. First diversification happens at Asset class level because different mutual fund schemes have different objectives, some of them may invest in Equities, some may invest in Gold and bonds. An individual investor can invest into different type of schemes and get diversified into different asset classes easily. The second level of diversification happens at securities level for investors. Like a scheme which is investing into shares and stocks will invest in to shares of many different companies.  An Equity mutual fund will generally have a portfolio of around 30 to 40 stocks. So when an investor invests in an equity fund he automatically gets diversified to 30 to 40 stocks. When we invest in 5 equity funds we may get diversified to the shares of more than 100 companies (considering some companies will be common) . It is very difficult for an individual investor to understand prospects of 100 companies and to invest in 100 companies and continuously do a research on them to take decisions of buying selling.

So by investing in Mutual funds an investor gets diversified to different asset classes and securities.

2) Professional Management: Mutual Fund companies appoint highly qualified fund managers and research analyst for continues research and effective management of portfolios of different scheme.  Also it uses highly expensive technologies for such research and analysis. When an individual investor carries his own research on different securities for his own investment, it is very difficult that he can meet the same excellence level which those professionals are maintaining due to their education, experience, use of technology and team work. In our day to day life we use services of many professionals like doctors, Chartered Accountants, Lawyers, Architects etc. similarly when it comes to investing in different asset classes and securities we should use services of these professionals. So by simply investing in different mutual funds an investor is getting service of all these professionals.  This professional management helps investors to reduce risk and improve on returns.

3) Effective Risk Management:  Risk Management is the most important aspect of investing and as discussed above, due to proper diversification and professional management of funds by fund management team in mutual funds, different type of risks reduces significantly. By diversification into different asset classes and securities the risk of investor reduces significantly. On the other hand, professional management by fund managers and research analyst further reduces the risk.

4) Reduction of Transaction Cost: All the type of costs related to fund managers, research analyst, expensive technologies or use of different entities like custodian, Registrar & Transfer agents etc. gets spread over large number of investors and huge amount of investments so their effect to individual investors reduces significantly which helps to reduce overall cost on an individual investor.

5) Liquidity: When individual investors  are holding securities and they want to liquidate those securities, sometimes they find it difficult to liquidate them immediately. Whereas in case of mutual funds when an investor wants to sell his units, mutual funds themselves buy them from investors in case of Open-ended schemes. In case of close ended schemes investor can sell them on stock exchanges where that scheme is listed. So mutual funds offer relatively easy liquidity options.

6) Well Regulated: All Mutual Funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors.  All the schemes are approved by SEBI and it continuously monitors functioning of the Mutual Funds.

7) Transparency: Mutual funds operate in a very transparent manner. They have to give different disclousers related to NAV, portfolio of schemes, expense ratios etc. to the investors, as per norms of SEBI. So investors get all the kind of information about their funds.

8) Convenience to Unit Holders: Mutual Funds offer convenience to investors in investing in different asset classes and different kind of securities at one window. All the processes are designed in a manner to provide operational convenience to investors. All the responsibilities like maintaining record of different securities, buying- selling securities timely, collecting interest and dividend of different securities in which schemes have invested etc. is on Mutual funds and not on individual investors. This makes an individual investors life easy.

Disadvantages: Also there are some disadvantages of investing through Mutual Funds, which are listed below.

1) No Tailor-Made Portfolio: Mutual fund is a pool of money so the portfolios of mutual fund schemes are created as per the objectives of the schemes and they a generalized. It is not possible to create a customized portfolio for an investor as per his choice. However, Mutual Funds offer different schemes with different investment objectives like in Equity oriented schemes they offer schemes investing in Large Cap stocks, Mid Cap stocks etc. So investors get a wide choice to select the schemes.

2) No Control Over Cost: Investor has no control over different types of costs incurred by the asset management company. He is charged fund management fees as long as he remains in the schemes. However, these fees are charged as per the regulations formed by SEBI and these fees are not significant against the benefits offered by Mutual funds. On the other hand, if an investor directly tires to higher such professionals for management of his fund the cost will be unbearable. Against that the cost he pays here is reasonable and bearable.

3) Managing a Portfolio of Funds: Due to availability of large number of schemes, investors sometimes get confused in choosing right scheme for themselves. This leads to investing in schemes which may not suit their objectives or investing to large number of schemes which they are not able to track. This can be managed by consulting qualified financial advisers.

4) Dilution: Although diversification is very important but investing in too many securities by mutual fund schemes sometimes leads to over dilution in portfolio which also dilutes the returns. So by investing in mutual fund schemes, portfolio of investors don’t go up sharply when an individual stock or security gives a high returns run but at the same time it doesn’t fall sharply when an individual security or stock falls sharply.

Conclusion: From above discussion it is very clear that mutual funds are effective tools to take allocation to different asset classes and securities.  They offer variety of advantages against investing directly in to different securities. There are small disadvantages also which can be managed by consulting qualified financial advisers. So rather than taking allocation to different asset classes and securities directly, investors should take the route of Mutual Fund Schemes.