What To Look At Before You Buy A Financial Product

Posted on December 14, 2010 by Ranjan

I posted this response to readers who were asking me where to invest on my old blog. Reposting this here. I have been guarded with my answers and start with the observation that since everyone has different financial goals and risk appetite, my recommendation may not work for him or her.

Since we are not talking about buying potatoes and onions, let me articulate on the things to look at before you make the buying decision.

Let’s take a look at some of the popular options available which are Bonds, Stocks, Real Estate, Mutual Funds (MFs), Unit Linked Insurance Policies (ULIP) and Exchange Traded Funds (ETF).

Now I’ll try to rate them on four parameters of investing. i.e. 1) Growth, 2) Liquidity, 3) Security and 4) Expenses

Growth: Stocks, MFs and ETFs top the rankings here. Over a period of over 5 years, the Compounded Annual Growth Rate (CAGR) is above 15% in comparison to 8% in Bonds. ULIPs begin to give a good growth only after 5 years or so because initially they are very expensive. Real estate is on a fairytale run these days too

Liquidity: Again, Stocks, MFs and ETFs score heavily while Bonds and ULIPs have a lock-in period or have substantial surrender charges. Real estate scores low here (You have to be lucky to get good buyers at the right time).

Security: I would rate all of them at par over a long-term of over 5 years. But you may get into a bad stock or real estate which are unsecured. Otherwise also, stocks and real estate are very volatile and can affect your blood pressure too!

Expenses: ETF is the least expensive with charges of around 0.5% compared to 2% from MFs and much more in ULIPs (especially in the initial years). Stocks too, are the least expensive, provided you get into the right stocks at the right time.

Based on the short analysis, I would recommend ETFs. Read more the 88% solution here. But as I said earlier, one man’s meat could be another man’s poison. Moreover, the diversification rule says that one should not keep all our eggs/ apples (for the vegetarians) in one basket.

So let us take a look at the various options, one at a time.

Shares: Investing in the equity market directly is exciting and sexy. You are in the thick of things and learn a lot in the process. Though the volatility and the information overload makes it a daunting task, investing in stocks is not rocket science. One should start with identifying a list of 10-15 companies out of 3-5 sectors which you know about and interests you. You can then keep a tab on their management team, financials, and future outlook and over a period of time, and will be able to take a call on them.

Real Estate: I feel that one has to be plain lucky to get into a good deal and be able to get the right buyer at the right price and time. I can’t think of any other factor other than luck. So if you feel you are blessed and have the right tip, go for it. Otherwise, it’s a no-no.

Mutual Funds: One should allocate their time to investment decisions in proportion to their income generation goals. Also, convenience and hassle free investing should be a major factor. Mutual Funds fit the bill where Fund Managers are into it full time. If you van identify fund managers who have consistently performed over last 3-5 years, nothing like it. The fund manager also has the muscle power of crores of Rupees and is able to take entry and exit decisions impartially. MFs continuously churn their portfolio. When MFs buy and sell stocks, they don’t have to pay capital gains as you would do when you churn. With Systematic Investment plans (SIP), you can start investing with as low as Rs 500 per month. But MFs have its own loading and administrative charges and the fund managers make merry on your hard earned money.

Exchange Traded Funds: Diversified equity funds usually have large expense ratios compared to index funds. For example, the expense ratio of Banking BeES, an index fund, is only 0.45, while it is anywhere between 2-2.50% for diversified equity schemes. That’s why I recommend ETFs.

ULIPs: Unit linked insurance policies combine two products, i.e. Insurance and Mutual Funds. In the initial few years, ULIPs are very expensive. But in case you don’t want any hassles of investing, and you have a tried and tested Insurance agent who is almost part of your family, then ULIPs are for you.

Bonds: For those of you who are risk averse.

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Financial Knowledge and Financial Literacy at the Household Level

Posted on November 1, 2010 by Ranjan

Down below is the abstract of the research paper by Alan L. Gustman, Thomas L. Steinmeier, Nahid Tabatabai.

In simple words, it says that just increasing your financial knowledge will not increase your wealth. (Related Post)
Knowledge is just one component of any Competency
Abstract:

This paper uses data from the Health and Retirement Study to explore
the mechanism that underlies the robust relation found in the
literature between cognitive ability, and in particular numeracy, and
wealth, income constant. We have a number of findings. First, the
more valuable the pension, the more knowledgeable are covered workers about their pensions.

We suggest that causality is more likely to run from pension wealth to pension knowledge, rather than the other way around.

Second, most measures of cognitive ability, including numeracy, are not significant determinants of pension and Social Security knowledge.

Third, standardizing for incomes and other factors, a pension of higher value does not substitute for other forms of wealth. Rather, counting pensions in total wealth, those with more valuable pensions save more for retirement, other things the same.

Fourth, there is no evidence that wealth held outside of pensions is influenced by knowledge of pensions.

In sum, numeracy does not influence wealth in whole or in part by
affecting financial knowledge of one’s pension plan, where financial
knowledge of the pension then influences other decisions about
retirement saving.

These findings raise questions about the mechanism that underlies the
relation between cognition, especially numeracy, and wealth. From a
policy perspective, they suggest that the numeracy-wealth relation should not be taken as evidence that increasing financial literacy will increase the wealth of households as they enter into retirement.

PDF link

What do you think?

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Investors Role in Building India

Posted on October 23, 2010 by Ranjan

Today, I spoke at the National Research Conference organized by Mumbai School of Business on the headline topic. I spoke on behalf of CGSI (Consumer Guidance Society of India).

The theme of the conference was “India Redined: Strategy for a Facelift” and had eminent speakers like Krishnan Khanna, Ravi Kumar (Director, KennisGroup), Amit Kapoor (SEBI).

I made the following points in my talk (Powerpoint free talk )

Started off with three questions 1. Do individual investors have a role? 2. What is the current situation and 3. How do we actually “Do It”?
While the Government and the business entities are “deficit economic units”, the individual is the surplus economic unit.
The surplus of the individual is channelised as savings and investment to the Government and business.
I interpreted Insurance as a protection against unemployment of the entire family. For example, if I die, the income of my dependents also stop and they become “Unemployed” which drags back the economy.
Investments in stocks and mutual funds channelize our savings into the business entities and thereby helping the economy.
Covering the present situation as part of question 2, I referred to the NCAER study which shows that:
- Even when 97% said that we must save, if chief earner expires, only 9% can survive more than 1 year upon the death of the chief earner.
- Even when 83% said that Health insurance is important, only 3% can manage as per their current planning.
- Even when 69% said pension planning is important, only 2% said they can manage as per their current planning.
- Even when 47% said growth is important, only 19% said that they are managing it well.
Coming to question 3 (how do we do it?), I outlined a 3 step action plan.
- Measure before you start managing it.
- Measure your assets and responsibilities.
- Measure your risk profile
- Measure your income and expenses and be aware of where’s it going.
- Search, Compare, Filter by using tools like the internet, consumer societies, forums.
- Take Action. Set Up Your Investments and Financial security.

I was the last speaker before lunch and we were running late. So I suspect that the applause was elaborate because I finished in 35 minutes and did not stand between my audience and their lunch!

Yes, I enjoyed giving the talk.

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Talk, Walk & Walk the Talk

Posted on September 28, 2010 by Ranjan

Yesterday, I had the pleasure of meeting Mr. Parag Parikh, Chairman PPFAS, who has written a very interesting book called “Value Investing and Behavioral Finance” published by TMH.

The takeaway for me was the remark by Mr. Parikh that he regards what he does as a “Profession” and not just a “Business”. Most of the people who provide financial services see their work as a business where their own profit motive takes precedence over what their clients need and requirements.

It’s a significant (and often ignored)point to remember while I build my business as a profession where ethics and value systems are paramount.

In the process of building a business (err.. a profession) in the financial services vertical, I am juggling with various elements of what I can offer. I see the following components of my profession.

1. To start with, there is my blog and website to organize information on personal finance. I also have an e-learning module on personal finance.

2. The RupeeManager software that can help you track and manage your money. I am also building some spreadsheets that can help you with a DIY Financial Planning/Budgeting.

3. The advisory services where I provide actual solutions to your investment needs and insurance needs. This involves a gamut of services like retirement planning, tax planning, credit management, liquidity management, financial review, etc.

1 is “Talk”, 2 is “Walk” and 3 is “Walking the Talk”

Walk and Talk

Your thoughts are most welcome.

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Financial Planning Is Simple And Easy

Posted on September 14, 2010 by Ranjan

Yesterday, I scared you with the assumptions that you need to make about Retirement Planning and how it ain’t easy. But the assumptions that I mention need not be 100% accurate and it’s more important to get started rather than focusing on the assumptions.

This post is about another perspective. It says that with a little common sense, planning your finances is really a breeze!

This is the story of Jagbir Singh, who has 7 years of experience in computing and has certifications like MySQL DBA, RHCE, CCNA, MCP, ACCP. He shares his thoughts, personal finance tips, investment approach etc. on his blog.

Jagbir Singh shared his financial decisions in the comments and wanted to know if he’s in the right direction.

I’d like to share his financial decisions:

1. Term Insurance splits in two policies: 1) 50 lacs from LIC. 2) 50 lacs from ICICI (iProtect).

2. Health insurance provided by employer, will purchase my own also soon.

3. Investments in Debt by EPF (automatically from salary deductions) and in PPF a/c.

4. Investments in Equity goes to MFs and in direct stocks in 40:60 ratio.

5. Investing MF part in 4 funds only through SIP: 1) HDFC Equity, 2) Sundaram Paribas Small and Mid Cap and ELSS funds 1) Canara Rebeco Tax Saving, 2) HDFC Tax Saver.

6. Purchasing stocks after deep analysis but still in basic stage (new comer). Will stop purchasing stocks directly if unable to beat index and MF returns over 1-2 years. Currently ahead of both in good margin.

Pretty impressive for a young software engineer, no?

Financial Planning is really very simple. You just need to be willing to make correct financial decisions and not be a personal finance expert. In fact, this is an area where you don’t need to be an expert to make correct decisions. Common sense and an open mind is what you need.

Nice to know that I have such intelligent readers! Thankyou, Jagbir for showing us that financial planning can be simple and easy!

Update: Like the 88% Solution! (As Guresh points out in the comments below)

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My Stock Investing Journey: Introduction

Posted on September 11, 2010 by Sumant Kant Sahai

Note: Please welcome my friend Sumant who wrote this post after much prodding. He’ll add a lot of value to readers and he has promised to share what he has learnt from his investments. This post is about the initial journey. And as he says, he was not dumb but just a part of the majority, I’m sure a lot of you would relate.

I was introduced to stock investing way back in 1994 or around. That seems ages back. It was, indeed, a different age. A world without an internet & a demat account indeed seems Stone Age.

Reading a book on Stock Investing was an easy part, as was memorising the Ratios for Stock Analysis. The difficult part was to get the data for Analysis. For an individual investor it was well neigh impossible.

I did exactly what most new investors do (Even today!). Follow the advice of the most approachable advisor. In any case I was neither equipped to judge the quality of the advisor, nor the quality of advice. And, promptly I bought a list of shares without knowing why I had bought them. All I knew was that there was money to be made at the Stock Exchange. Why I needed more money never crossed my mind & I did not know I should ask that question to myself. The concept of Personal Financial Goals was still more than a decade away from me. Those were rather carefree days of my early career, as it is for an overwhelming majority.

Come to think of it, the timing was not bad. Harshad bhai had come & gone & the market was still in consolidation phase. But I knew nothing about where I was putting my money & why. Add to that, the pain of safe keeping of the share documents. And there was this vague fear of keeping account of the income from the shares. After all I will have to account for it in my Income Tax Statement. I could not understand the basic Income Tax Form to be submitted with the Form 16 (given by the Employer). This income from shares would complicate the things. I was scared. Please do no laugh. I actually had a vague fear of managing all that mumbo-jumbo. I was a very law abiding citizen & I was expecting to make big money at the Stock Exchange!

The problems did not end there. It was tough to keep track of the Share prices. Forget about Ratio Analysis & all that. That was only meant for serious Analysts, who would get published in the Dalal street, Financial Express, etc.

It did not take very long to get totally frustrated. As luck would have it, the shares I had bought were not doing well. If I had been lucky, my story might entirely be different. It is easy to see how important a part Providence plays in our life!!

I gave up. I just folded all the Share Certificates & locked them in safe-keeping (!). They were to remain there for almost a decade & more!!

Things may have been different if:

I had made money in my first few transactions. But, again that would have been purely a matter of luck.
I had read enough about Indirect & Direct Investing and chosen the Indirect Route to Investing & put in a small amount through the Direct Route to learn the tricks. That would probably have given me enough time in the market to learn the tricks & also given my shares enough time in the market to perform (& give a realistic return). It is difficult to accept & understand a realistic rate of return in Stock Market. One has to accept that the Stock Market, after all, is not a currency minting machine.
I had a Financial Goal. Even as simple a goal as having a flat of my own in Mumbai (then, Bombay). That would have probably given me a sound reason to make more money & a target. (Believe me. Till then I only knew that surplus money was something you just kept in the bank!! Please do not conclude that I was dumb. I have a feeling, like always, I was a part of a majority.) I would possibly have been more realistic in my expectations. Would probably have been more patient.
I were experimenting in 2005/06 & not 1993/94. I may possibly have read the blogs of many a stock investor & absorbed some wisdom. That is again providence & far fetched.

Anyway, I was off Stock Market & none too wiser. But, of course, I had all the reasons. My favourite argument was:

“While one person is selling the shares & feeling smart, the other buys & feels he is smarter. Both of them cannot be correct. I think the person who is better informed will be smarter. I reasoned that I will always be the loser because of my limited knowledge compared to those who are in the trade full time.”

Nothing wrong in the logic. Except that it got me nowhere. With logic you can justify any thing in the world. It is often just a cover for your lack of knowledge & wisdom or plain hard work & application.

Now I can say that, indeed in the long run the money in the Stock Exchange can come only from the Value created in the factories & offices. So almost everybody should be a winner if you are buying/selling scrips that create value, seen from a long term. In the short term, however, there are a host of factors that drive up or down a scrip. Most important of all, I think, is market sentiment.

The most important principle, therefore, is to be able to identify businesses that would perform well & stay invested till you think that the business will continue to do so. Of course, the valuations are important. But if you are a long term investor (You should be, if Stock Investing is not your primary source of income!) current valuation of a scrip is much less important than the quality of the business & its future prospects. And, there are simple mechanisms whereby you may even out the valuation of purchase. By investing through SIP, for example.

Let me get back to explaining my favourite argument against stock investing:

“If one person is buying and the other is selling, both may be winners. The first may be in need of cash, or he may just have made his targeted profit. The other may be buying it for the long term or he may still be seeing value in the stock. Indeed, ‘Time’ is a major factor in stock investing.”

Needless to say, today I am a firm believer in the power of Stock Investing. It is a sure way of making your savings work for you. It is a tool to achieve your Financial Goals. It is a tool whereby you can participate in the great Indian success story that is unfolding.

Sumant Kant Sahai

PS: Checkout my next post on this blog to find out how I re-discovered the Stock Market.

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Asset Allocation Revisited

Posted on September 7, 2010 by Ranjan

Asset Allocation (AA) sounds sophisticated, no? It assumes you have an asset to allocate and gives a boost to your ego, eh! Looks like a smart and sexy word for a thing as drab and dreary as planning your personal finance. And AA also gives you a feeling that you are holding some aces (AA) rolled up in your sleeves.

But, despite being a sophisticated term, it actually is a very simple and boring way of managing your investments. Especially when you compare it with timing the markets or with picking up multibagger stocks. Both timing the market and picking up stocks sets your heart racing. With asset allocation, your investments are on an auto pilot.

What is asset allocation? It is the method of investing based on the study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991. They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. This traditional buy and hold method is boring – but it works.

Asset allocation is the percentage distribution of your money into equity, debt and liquid instruments. Equity, as you know, gives the highest growth but comes with the highest risk. Debt instruments are more or less guaranteed but give you a lesser return. Liquid money is your money in your savings account.

Let’s start with the thumb rule of AA. Your allocation to debt should be equal to your age. And as you age, the percentage in debt should increase too. In other words, your investments in equity should be (100- your age).

But AA should be much more dynamic than the above thumb rule. I feel that it should depend on your age and your risk appetite. Guys at 20-25 years of age may want to invest everything into equities and I think that is the right strategy.

And before you set off to do some Asset Allocation for yourself, I would like you to ask the following questions to yourself:
1. What is your risk appetite?
2. What are your financial goals?
3. When do you need the money?

The answer to the first question is a choice between a conservative and an aggressive investor. If you are conservative you allocate a greater percentage into debt and bonds. If you are aggressive your allocation has less debt and bond and more mid, small and large cap stock. Aggressive allocations will probably have a better rate of return over time than going conservative, but will be the most volatile, meaning your values will fluctuate up and down more. In other words it’s a trade off between lower returns and the large fluctuations.

The answer to the second and the third question should also be a factor in your asset allocation decision. For example if you have ambitious financial goals, it would be a good idea to have a greater allocation for stocks. And if you need the money in a short period of time, you wouldn’t like to lock it up in illiquid investments.

And if you love ready made formulas, here’s some from allocation strategies: To make it simple, we have taken out the percentage that should be in your saving account ( liquid instrument)

• Older investor (Conservative) : 30% equity; 70% debt
• Older investor (Aggressive) : 50% equity; 50% debt
• Young investor (Conservative) : 80% equity; 20% debt
• Young investor (Aggressive) : 95% equity; 5% debt

Rebalance Your Portfolio: Even though asset allocation is a simple way of putting your investments on auto pilot, the success of this strategy lies in monitoring it regularly. Look, even when we have advanced technology to run a supersonic jet, we need pilots to monitor the dashboard and take corrective action. Similarly, we need to rebalance the portfolio regularly. What does this rebalancing mean?

Let’s say your investment in stocks/equity go up 5 percent, while your investments in bonds decline by 1 percent. If you have holdings in both areas, the percentage of your portfolio that’s in stocks has grown a bit, and the debt portion has shrunk a little. Over time, this process can really change the face of your portfolio — especially if you continue to reinvest your earnings without ever rebalancing.
So while you started with a 70% in stocks and 30% in debt/bonds, after a few months, you can end up at 80% stocks and 20% debt/bonds, as the stocks have been growing much faster than the bonds.
To be more lucid, let’s take a hypothetical example of a starting portfolio of Rs 10 lacs. You have invested Rs 7 lacs in stocks (70%) and the balance Rs 3 lacs in bonds. As your stocks grow faster to Rs 9.75 lacs and the bonds grow to Rs 3.25 lacs, your asset allocation is now 9.75/13 = 75% stocks and 3.25/13 = 25% bonds. What do you do now?

Actually this is the most difficult part. While your stocks are doing well, you have to take out your investments in stocks and put them into debt. To make it 70-30 again, Rs 65000 out of stocks and invest them into bonds. So the balance stocks portfolio is Rs 9.1 lacs which amount to 70% of Rs 13 lacs. So you are honouring your asset allocation decision again. But as I said, this is easier said than done.

But look at the benefits again. Moreover by honouring your asset allocation decision, you are automatically selling when the stocks are on a high and buying when the going is tough. This is what the experts really do. By being a contrarian investor, you are not letting in fear and greed guide your decision. And you are smarter than the majority!

Adjust Your Portfolio as You Near Retirement: As you get older and closer to retirement, it’s obviously important to have enough money in less risky, more predictable investments. So, rebalancing your portfolio with age is also a sensible decision.

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