Wednesday, July 22, 2009

Part 3: Starting to worry about investments

Have you nominated one of your bank accounts as the "Third Bank Account"? (We can refer to this as the TBA going forward).  Have you made it investment-ready by linking it to a Demat and Trading account?  If you have not done so yet, you should seriously consider acting on it soon.

Now that we have resolved to set aside some money every month, the next problem is what to do with it?   Before addressing that question however, let us first talk about inflation.

What exactly is the meaning of ten thousand rupees?  It has no meaning except in relation to what it can buy.  What this money bought for you five years ago, is far more than what it buys today.  What it buys today will be far less than what it will buy five years hence.  Inflation, or the rise in the general level of prices eats up your money - it erodes it away slowly and imperceptibly - and before you know it, you are poorer than when you started out! 

The level of inflation keeps changing with time.  The official government statistics report inflation based on wholesale prices of a pre-defined basket of commodities.  This may be quite different from the inflation you face in your daily life since you shop in retail and your basket of consumption is different.  In the last one year, you would have noticed that prices of essential food items have increased far beyond the inflation figures reported in the newspaper.   Just check the price of Tur Dal in case you have not noticed.  Or the price of idly-wada at the local Darshini.

The technicalities of how inflation is caused and how it is computed need not bother us at this moment.  What we need to note is that money kept under the mattress, though high on the sense-of-security scale, is quite low on the sensible-thing-to-do scale!  You have to make your money grow or it becomes useless with time. 

If you have invested your money in a Fixed Deposit (FD) with a bank and the rate of interest that you earn is 8% p.a. and if inflation is, say, 6% per annum, then your nominal rate of interest/return is 8%, while your real rate of return is just 2%. The real rate of return is the actual increase in purchasing power.

You need to invest your money in assets that will grow in value over a period of time. Before diving into the different assets, let us first pause and think. Do we know what is an asset? 

Your car is not an asset.  It drops in value by 30% the moment you drive it out of the showroom and then keeps depreciating.  You also have to spend money on maintaining it.  Gold ornaments are not assets. Try selling the gold chain you bought yesterday, and you will know; you will get at least 25% less for it.  Buying a sofa for the house is not an asset.  You will probably get less than 20% of the value when you go to sell it, if you are lucky.  Since they are not assets, none of these items can be bought out of the money in the TBA; nor can the emi's on loans taken for buying them be paid out of this account.  If your regular expense account supports it, by all means go buy it.

Do stocks increase in value?  They may or they may not; but you invest in them on the expectation that they will.  It’s just that the risk of losing part of your principal is high since their prices are volatile and they don’t respect your purchase price.  Do Fixed Deposits increase in value?  You bet they do.  At a steady predictable rate without any volatility. If someone offered you an option to invest in an 8% FD vs. investing in a stock that is likely to yield 8% over the long term, what would you do?  You would obviously invest in the FD.  Since the expected rate of return is the same, you would (and should) prefer the certain cash flow to the uncertain one.  Assuming FD’s return 8%, what should your expected rate of return be, on equity stocks to compensate for the additional risk, which includes losing your capital?  You need not quantify the number; you just need to understand that volatility of return means risk; risk of losing part of your capital constitutes risk; and you need a premium over the normal return on debt to compensate for the additional risk.

What we spoke about above is the risk due to variability of return. The other and more fundamental risk is the risk of default.  Even within debt instruments, why does an unknown finance company offer more return than a co-operative bank, which yields more than an SBI deposit? The additional interest rate that you get is default premium.  Debt instruments are usually compared with SBI rates, or Government bonds, since all other instruments need to pay a premium over sovereign risk.

Higher the risk, higher the return you should expect.  In real life, the returns do not match the risks involved in direct proportion thus making certain financial decisions easier.  You should not invest in a plantation scheme since the promised rate of return may be high, but the probability of seeing your teak tree after twenty years is close to nil.  You can lend to your brother-in-law to maintain peace with your spouse; but from a risk-return perspective it is unlikely to pass muster.

Reflect on that.  If you have lent money to your brother-in-law start thinking about how to get it back.  We’ll meet again in the next issue.


Dinesh Gopalan
Fidelity India Finance
mobile: 9845257313

Wednesday, July 8, 2009

Part 2: Where does all the money go?

July 8, 2009

Hello All,

In the last issue we saw what could be the meaning of a "nest egg" or retirement corpus.  I hope you have had time to reflect on what your retirement number might be.  It's not an easy number; neither is it easy to answer the question "what would you do after retirement in case you had enough money to retire?". We don't realize how much we owe to our jobs - it gives us a reason to exist - at the very least, a reason to fill our days with some purpose.  Anyway, I'm sure most of us have a lot of time to figure out the answer to that one!  In the meanwhile, we continue to work, and continue to wonder where all the money went!

Talking of where the money went, do you know where yours went?  Try this small experiment.  List out what you think have been your expenses in the past three months in broad categories.  Once you get that number, compare it with how much you actually withdrew from the bank or cut out as cheques.  The difference is likely to be staggering.  The money just goes; you don't know where.  A little here, a little there, and it's gone - there's no way you can keep track of it.

Talking of investment, etc. is all fine, but first we have to understand how to put aside money.  In the absence of that, all talk of investments is just theory.

The key to solving this puzzle is to understand human psychology.  Do you miss your PF money that gets deducted every month?  Have you ever wished that you could have gone on that vacation in case the PF money had not been deducted for the last one year?  In most (as in 100%) of the cases, the answer is No.  Why is that?  That's because the money was never yours in the first place.  It got deducted at source.  So you never got used to considering that money as yours.

Your neighbor earns probably 3/4ths of the amount you do.  He stays in the same apartment complex, seems to enjoy the same lifestyle, and seems to be, on balance, as happy or unhappy as you are.  He has children and mother-in-law worries just as you do. (In case you're not married make that girlfriend/boyfriend worries).  In that case, why is it that you are not able to save 1/4th of your salary at least?  That's because, try as you might, the money just seems to get spent!

What happens when you get your annual bonus?  When you find that you have a balance of a couple of lakhs in your account?  The mind is very ingenious - it can think of a hundred different things that you absolutely need to have, but don't have.  In short, you are deprived, and you need to address the deprivation immediately.  How about that LCD TV?  If the Agarwals next door can go abroad every year, why not us?  And Kaya skin clinic has a new Botox treatment…. The list is endless.

Utilize human psychology to your advantage.  Put money aside by Paying Yourself First.

Let me explain what I mean.  List down your entire income for the year.  This includes annual inflows like bonus as well.  If you have a spouse and he/she works, list their income as well.  Now, plan what you want to (that should read as "have to") spend for the entire year.  Include all annual outflows like vacations and school fees.  Then follows a simple (A) minus (B) - and what do you get - voila, your savings for the year!  (If A – B is negative, stop reading further. I can’t help you; no one can).

How do you ensure that this planned savings actually happens?

Take your "annual spending" target above, divide it by 12: that's your monthly spending target.  Please note, we have derived a monthly spending target, and not a saving target.  Assuming you have two bank accounts (one yours; one your partner's), open a "Third Bank Account" for diverting this savings.  Every month, as soon as you get your salary, retain only what you have decided is your spending target; cut yourself a cheque for the balance.  Deposit this cheque in your Third Bank Account.  And school yourself to think of this account just as you think of your PF viz., not think of it at all!  Except to worry about how to invest it of course.

Do choose a bank which has demat account facilities and a trading desk as well - while you are at it, you might as well make it investment friendly.  Adhere to the corporate policy on this - make sure it is part of Fidelity's approved list of banks for this purpose.

Do you realize what you have just done?  You have ensured that you will start living within the means that you have set for yourself.  If you continue on your old dissolute ways, you will know by the middle of the month, when you run out of money.  You can't touch the Third Bank Account, since that is out of bounds.  As they say in Kannada you will learn to "Adjust Maadi"! 

Why did we have a spending target and not a savings target? That is to take care of the annual inflows like bonus - having a spending target will ensure that that money goes straight into the Third Bank Account.  The other beauty of this scheme is that you can now spend without guilt, since you have already taken care of the savings aspect.

As to what is to be done with the money kept aside for investment - that will be the subject of several more articles to follow.  However, like I said, all that is theoretical, if you don't "Pay Yourself First" and "Open a Third Bank Account".  Do it!  Do it now!!

And start training yourself to live with some amount of deprivation. 

Adios… till we meet again in the next issue, fifteen days from now!