Tuesday, May 3, 2011

The Quandary of Investing

Have you ever had a relative or family friend call you up and tell you - “Now that you are earning, have you thought about your future and investments to save tax?” And you are surprised and start thinking as to why your relative/family friend suddenly was interested in you saving tax and making investments, till they drop in their next line – “ I am an ‘investment advisor’ and I have this product wherein you have to make yearly payments and you see an overwhelming return on your investment.” You now really don’t know what to say and then he/she starts off with the story of how Mr. Ravi – another relative/family friend that both of you are acquainted with, doubled his money in 2-3 years by investing in this particular fund/instrument. If you are somebody who earns more than Rs 50,000 per month (varies from bank to bank), you may even have ‘wealth advisors’ call you from your bank who would want to advise you on investments! A few of my classmates from my MBA class are wealth advisors with certain banks and from what they have told me, you really wouldn’t want to take your wealth advisor’s call seriously especially if the advice comes ‘free since you are a premium client’. Wealth advisors in most banks are given a target of the number of products to sell and these poor souls call up their clients and try to pitch in as many products as possible! So much for wealth management!

When I first started earning, I did have a few ‘concerned’ people around me who were ‘advisors’ for some ULIP (Unit Linked Insurance Plan) or mutual fund product. Naive that I was, I ended up putting in my savings into funds which had suffixes as ‘wealth maximiser’ or ‘growth opportunities’ etc. A few years later having got extremely mediocre returns from those funds with fancy names and having sat through several finance lectures in the 2 years I spent doing my MBA, I would like to help you from ending up with a mediocre investment product.
I’ll first start by replacing fancy sounding names like ‘investment advisors’ (what your relative/friend) claimed to be with more realistic names. An ‘Investment advisor’ selling a particular product is simply an ‘AGENT’. The agent gets commission on every sale he/she makes. When an agent sells a ULIP (Unit Linked Insurance Plan) product, he/she receives about 15-25% of your first year premium and 5% of your premium every year you make the payment. So if you are paying Rs 20,000 a year as the ‘investment amount’, then the agent gets about Rs. 3000 – 5000 during year 1 and Rs 1000-2000 from the second year onwards. No prizes for guessing where this amount comes from. So your over-enthusiastic relative makes a lot of money thanks to you.  
The most commonly sold investment products for tax planning are listed below with a brief explanation on the product:

This is probably the most mis-sold product and your agent would be extremely enthusiastic about selling this product since this product is one of those paying the highest commissions. A ULIP is often advertised as mix of insurance and investment. Your agent would probably tell you that it is a combination of insurance and a mutual fund. A ULIP works on a very simple premise. The money you pay every year is called the premium (since this is an insurance product) and after deducting an Entry Load (a certain percentage is cut from the initial amount you invest as charges) and allocating some money for mortality charges and other charges, the remaining money is invested in equities and is managed by a fund manager. The fund manager would also take fund management charges of 2-3% annually (this is taken irrespective of the fund’s performance). In its current form you have to compulsorily make premium payments for the first 3 years and then your further payments are usually optional. Hence ULIPs have their maximum charges in their first 3 years.

ULIPs are good only if you are investing for a specific need like a Children’s Plan or a Retirement Plan (where some assured amount is guaranteed) and if you intend to pay premiums for the entire 10-20 year period of your ULIP. Do not invest in a ULIP if

a.       You intend to invest for just 3 – 5 years and then surrender your ULIP
b.      You want insurance and investment growth through equity investments! If you want insurance please buy a term insurance product (viz. a lot cheaper) and a mutual fund (again a lot cheaper than a ULIP) separately. Please do not mix up both these investment objectives. You may achieve neither of these objectives and would pay a large fee in the bargain
c.       You are worried about stock market fluctuation and equities. Most ULIPs invest your premiums in the stock market
d.      Out of an obligation to the ‘advisor’ who is a close relative/ family friend

Every ULIP has a 2 week look-in period wherein you could return the ULIP and the company has to refund your premium. In case you feel you have been short changed by your ‘advisor’ who made tall claims but the ULIP document spoke something else, you can return it. Your advisor would not tell you this but this is possible.
Once again I would like to point out that a ULIP is a really long term product (10 years or more to give a good return), do not buy one if you have an investment horizon of less than 5 years.

TO read more about ULIPs and its hidden charges, please refer to the ULIPs page.

2.       Mutual Funds:

A mutual fund is an instrument which pools in the money of several investors and the fund manager buys equities, bonds or commodities (depending on the type of the fund) on behalf of those investors. When you invest a certain amount of money you are allotted units at a certain NAV (the price of each unit). As the mutual fund makes gains on its investment, the NAV goes up and you end up with gains on your investment.

If you want to invest in the stock market and are not confident on buying equities on your own, mutual funds are your best bet. There are ELSS (Equity Linked Savings Scheme) classes of mutual funds which have a 3 year lock-in period which even offer tax relief under Section 80C. Mutual funds usually have a low entry load compared to ULIPS and at times no entry load at all. For more information on mutual funds and to get a ranking of the top mutual funds in India, please check the mutual funds tab on top of the page.

3.       Insurance

The word Insurance by definition is 'A promise of compensation for specific future potential losses in exchange for a periodic regular payment'. In simple terms you avoid incurring a loss due to some calamity by paying a certain amount of money called 'premiums'. In case the calamity occurs, you get a previously agreed upon amount, thus protecting you from a loss.

Now this is the very objective and definition of Insurance. Never make the mistake of mixing Insurance and investment. If you have dependants it is wise to take insurance. You could take a simple term insurance which at a relatively small premium could provide an adequate cover.

4.       Employee Provident Fund:

The Employee Provident Fund or “Provident Fund’ or simply ‘PF’ as it is commonly known is a safe investment which currently offers a return of 9.5% a year. This is a class of investment that your dad would be glad that you have since it is ‘safe’ (read gives a fixed return) and has been around a really long time. Though they do not give the type of return equities give you, they are an almost zero risk investment and over time, your investments compounded at 9.5% per annum would lead to a decent sum notwithstanding the fact that they provide tax relief under section 80C. I would personally recommend investing a certain portion of your income in PFs if you are a person with medium to low risk appetite.

5.       Fixed Deposits:

Another one of your Dad’s favorite investments – the Fixed Deposit in a bank or an NBFC (Non Banking Financial Company)! The terms of a Fixed Deposit are simple – you deposit a certain amount of money in a bank for a certain period for a certain fixed interest rate. It is again an almost zero risk investment unless your bank goes bust, but Indian banks are well capitalized and the likelihood of a bank going bust is pretty low.

You can earn a tax relief on your Fixed Deposits or FD if your term is 5 years or more but for a fixed deposit, there is a TDS (Tax Deducted at Source) of 10% on the interest the bank pays you if the interest earned by you is more than Rs 10,000. For eg. If you put Rs 150,000 in an FD and earn an interest of Rs 12000, Rs. 1200 is cut as TDS.

To read more about TDS and know about the special conditions under which one can receive an exemption from TDS being charged, please go through the Fixed Instruments page.

I would be happy to answer any queries you may have and you could post your queries as comments on this page and I shall get back to them as soon as I can.

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