Part 7: Why do we fall for these?

There are several schemes in this world which are designed to enrich everyone but yourself.  There are some things which are akin to cutting your veins, and keeping you comatose till you bleed to death.  There are certain tools which give you lot of power; but used wrongly, could lead to your destruction. Keeping balances on a credit card and paying interest on them belongs to all the above categories.

You want to pay interest at 3% per month? ... that works out to 42% per annum (it is compounded monthly).  You have to earn 61% interest before tax to be able to pay 42% on the other side.  Or, to put it differently, if you invest a lakh of rupees at 42% per annum for 10 years, what would it end up amounting to?  Work that out yourself – keep a glass of water handy.

If you paid only the “minimum” amount due of 5%, and the rate of interest is 3% (per month of course) – how many years would it take you to clear your dues and what would you have paid out by the end of it?  I don’t want to put down the number here – I find it quite horrific.

Did you go and buy that pair of Levi’s jeans on three installments – No way you say, “I can afford my jeans!”  Ok Ok, what about that TV, or that foreign vacation?  Your spouse was nagging you, so you charged your card.  And donated in blood for the rest of the year!

You are just comforting yourself saying you pay most of your dues on time anyway.  All you do is carry forward a “few” balances “sometimes”.  Here is what happens if you do.  Even if you have one rupee as balance on your card beyond the due date, you are charged interest for all fresh purchases from the date of purchase.  And you thought they were giving you a “free” credit period.  How Naïve.

The credit card company calls you and offers to increase the credit limit on your card and you grab the offer. Why would you want to, considering that you should not be carrying forward balances in the first place?  If your card were to be stolen, and used for a shopping spree, would you not be protected better if you had a lower credit limit?  More importantly, is not a lower credit limit better for your wellbeing?

What about the rush of power and feel-good feeling of euphoria that you get when you make that impulsive purchase and swipe your card for it? The feeling that you’re on top of the world – that you can afford anything?  Research has proved that you tend to over-spend when you use the card – counting out notes and handing them over, on the other hand, has a very sobering influence.

Just to make you feel better – having a card is not a bad thing at all, provided you pay off all your dues before the due date.  Before moving on to something else let us repeat a short prayer: “Oh Lord, this day I resolve to pay all my dues on time; especially credit card dues.  Forgive me for all my sins and keep me away from card balances. Amen!”

“Spend more to save more!”  “The more you shop, the more you save!”  “The more you spend, the more reward points you earn!”  You see such exhortations all the time.  I don’t think I need to spend time on dwelling on the absurdity of it.

“Become a Purple Citizen” – you are eligible to get a membership card to our store and you get the most exclusive privileges when you shop!  Our gatekeeper will salute you twice!  You will get a cola with crushed ice! And if you shop more than x thousand rupees a month, you will be elevated to Silver category.  Which is when you will look at the Gold member and feel envious – because the crushed ice in her cola is made of Evian water.  Gimmicks to get you back to the store and make you shop more.  The reward points usually work out to a discount of 1 to 2%; and stores that offer such schemes are usually more expensive than the market-street ones by at least 20%.

What about the store in Bangalore which has a “half price sale” for a month at a time every six months?  That place is my favorite shop – I land up there whenever there is a sale.  Don’t glare at me – I am human too!

I used to go to the movies often.  Till they razed all the old cinema halls down and built multiplexes. And raised the ticket prices by a few hundred percent. I still go often, but with greater reluctance – that’s because my wife’s party circuit swaps stories about the latest movies they saw; and my son only likes popcorn when he pays 50 rupees a pop.  The mineral water bottles there come in special sizes: that’s because it is illegal to sell above MRP – so they created a special size with a special rate, just for multiplexes! 

The one-rupee tickets offered by the airlines are great.  Except that the taxes are 2500 rupees.  We have got such wonderful bargains whenever we travelled in the last one year.  My travel spend for the family was rupees eighty thousand this year.  We are thrilled since the journeys were worth at least double that.  The year before that, I travelled as often and spent only rupees twelve thousand – we used to travel by train.

Oh, the frailties of human nature!  And who understands these better than salespeople?

I had a couple more interesting things to share – but I’ve got to run.  We’ve just got tickets to the latest blockbuster in town – free!  Westside gifted them to us as reward for our Dussera shopping.  And did I tell you – the doorman there knows us by name!

Bye for now!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313

Part 6: An immediate action plan for investments

It is one thing to learn all the concepts before getting into the meat of a subject.  It is quite another to wait for an indefinite time period for some practical suggestions on what is to be done in the immediate near term.  Concepts are fine, and we need them to enable us to make our own decisions, but we need to be practical as well!

I just realized that there are quite a few concepts/theories still to be covered.  I also realize that I run the risk of losing the attention of my audience (I am making a big assumption here – that you have been avidly devouring every word written so far)!

So, what are those things that you can do right away in terms of a concrete action plan for your investments?  I am assuming that you already have a Third Bank Account and you have made it investment ready.  I am assuming you know how mutual funds work (at least the basics – we shall go in depth later).  And I am assuming that you do have some money set aside in a form that can be easily liquidated in case you have to make some adjustments to your investment portfolio.

If you strip the subject of all its complications and jargon, it’s not really that difficult. 

Do you have credit card balances?  Are you in the habit of carrying forward the dues and paying interest on them?  In case you did not realize it, the interest rates on cards are in excess of 40% per annum.  Your first priority should be to repay all your card (or cards’) dues.

Do you have an emergency fund to cover for three to six months’ expenses?  If you don’t, your next step would be to build that up.  This money should necessarily be in the bank – either in the savings account, or in easily cancellable fixed deposits.  Whether it is three months’ worth of expenses or six months’, I leave that to you to decide.  It depends on what  your spending patterns are, and what kind of social support systems you have.  You don’t want to be facing a sudden medical or family emergency without some liquid cash in hand.

Do you foresee some expenses hitting you in the near future – within the next couple of years?  It could be for marriage, for a house, for education, etc.  When you are keeping aside money for this, remember not to invest in “long-term” investments like equity shares or real estate.  This money should be preferably kept in Bank FD’s or in debt mutual funds that invest in securities of short-term maturity.  You could target the “liquid funds” or “short term debt funds”. 

Once you have taken care of these, whatever is left (the moment of revelation arrives – do you have anything left at all? J ) is for the long term.  Whatever is for the long term can be invested in avenues that are likely to offer a larger rate of return, though with some amount of risk and unpredictability due to volatility.  You could first keep aside some portion for investing in Debt Mutual Funds.  Your typical “Income Fund” of any fund house should fit the bill perfectly. You could also invest in equity mutual funds; or you could invest in Gold.  If you invest in equity mutual funds, pick out a large “diversified equity fund” of any major fund house. For Gold, you could look at Gold ETF’s which are traded just like shares; that is where you pay the least amount of trading margins / dealer profits. Remember, buying gold ornaments does not count as investment – at least not in my book.  You could look at buying gold biscuits (available in any quantity five grams onwards) – if you do, remember it is better to buy it from a jeweler rather than from a bank – the margins charged by banks are huge and unnecessary.

Depending on how much money you have at your disposal you could keep an eye out for buying that property or piece of land.  If it is your first and primary house which you need to buy –don’t delay – take that big loan and do it right away.  If you are already living in your own house (and probably paying a huge emi on it), and are looking for a second property, right now seems to be a good time.  The real estate markets, after a huge rally, have seen some correction in the last one year.  The market seems to be firming up now –  the potential upside is quite good. You should of course be prepared for the long haul – in real estate, the returns are normally good, but over a time frame extending to a decade or more. When you do buy that property, you are fully entitled to sell off all the other investments you have– keeping some emergency funds as a back-up, of course.

Do you have insurance policies that are running on which you are paying regular premiums?  We shall have a lot of things to say on insurance – but that has to wait for later.  For the time being, continue paying your premiums.  Before investing in any new insurance product however, pause: my advice would be to go in for “pure term insurance” where you pay only for life cover and where there is no savings/investment element involved.  The typical premium you will pay will be about Rs. 300 per lakh of life cover per year, for a thirty-year old. 

If you are keen on knowing more about how to manage your own finances and want to build up that mind-set over a period of time, it is not a bad idea to start reading up on the subject.  I would seriously recommend that you subscribe to “Outlook Money” and “Money Today”.

Do all this and you are all set, at least for a reasonable period of time.  In the meanwhile you can continue to pick up more on the subject so that you get more comfortable analyzing options and preparing to make your own financial decisions.

I know that I have covered a lot of ground above, which assumes a basic understanding of some underlying concepts.  We shall be covering all that one by one in subsequent issues.

Happy Investing!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313

Part 5: All about returns - time for some math

Pay Yourself first. Open a Third Bank Account. Make it investment ready. Have a spending target. Put the balance into the TBA.

Understand that there are different kinds of risk – Physical risk, Risk of default a.k.a. Credit Risk, Risk due to inherent volatility, and Interest Rate Risk.  Evaluate assets on the criteria of Risk, Return and Liquidity.  In general, higher risk needs to be compensated by higher return.  Now that we have done some revision, we can move ahead!

Talking about return, it is measured in terms of percent per annum.  What would Rs. 10,000 in an 8% fixed deposit amount to, in five years?  Dredging our memories will yield the compound interest formulae last used in Class Six:

Amount = Principal x  (1 + Rate/100) ^ Period

Hence in this case, (10,000) x (1.08)^5 = Rs. 14,693, i.e. 1.47 times your Principal. 

8% for ten years works out to 2.16 times; twenty years to 4.66 times; thirty years to 10.6 times; forty years to 21.72 times; fifty years to 46.9 times; sixty years to 101.2 times;   Notice that as the time period increases, the rate of increase increases too!

Over a thirty year time period: 8% yields 10.06 times; 10%, 17.45 times; 12%, 30 times; 14%, 51 times; and 16%, 86 times.  Notice that over a long time period, an arithmetical increase in interest rate results in an exponential increase in return!

Moral of the story?  Every one percent increase in interest rate matters over the long term.  And the longer the time period, the more the beneficial effects of compounding.

Compound interest is the eighth wonder of the world! To use this principle to your advantage, you need to resist the itchy-fingers syndrome – once your money is invested somewhere, don’t give in to the temptation of booking profits in a hurry – be in it for the long term!

Continuing with the above example, if your Rs.10,000 is invested at 8% for 30 years it grows to Rs. 100,626.  If inflation in the meanwhile was running at 6%, what is your Rs. 100,626 thirty years hence worth in today’s terms?  That would obviously be:

100,626 / (1.06)^30 = 17,520 in today’s terms.  You can imagine what will happen if you keep your money lying around without earning interest.

Your grandfather bought a piece of land 50 years back at Rs.50,000.  It is worth 1.25 crores today.  You don’t have access to Excel – how would you calculate the approximate rate of return using only an ordinary calculator?  The money has grown 250 times.  2 raised to 8 is close to 250 (256).  Hence the money has doubled 8 times – 50/8 gives one doubling per 6.25 years.  If your money doubles in 6.25 years, what is the rate of interest?  It’s not 100 / 6.25 since it is compound interest we are talking about.  When you are dealing with compound interest you should use the “rule of 72” – calculate 72 / 6.25.  That gives 11.52 percent.  The actual rate works out 11.68 percent which is close enough. Remember the “rule of 72”.  It’s useful.

In the financial world 1% is sometimes referred to as 100 basis points.  So, an increase of 25 basis points means a 0.25% increase.

How does one measure Risk?  Let us say you are evaluating which mutual fund is better among a range of options.  They are all similar Equity Funds and all of them measure their performance against the BSE Index.  You first list down the “returns” that each of them has generated, say, in the last five years, along with the return on the BSE Index for comparison.  The absolute return is one measure and it’s a good one; but how do you account for the fact that some funds may be following a more risky investment strategy, i.e. their returns may be more volatile in comparison to other funds? Here you need some measure of measuring “risk” which in this case means the risk inherent in variability of returns.  There are several specific formulae to measure this (which we shall see much later in this series) but in general the principle followed is the same.  In order to measure risk, what is measured is the range and amount of deviation of the yearly (or any period’s) return from the average/mean return for each particular fund.  The resultant number, whichever formula is used, indicates the “risk” in the investment strategy followed by fund.

Coming back to the subject of “return” - you must use the principles explained above to discount any future returns to today’s terms in order to compare two different options.  Let me illustrate this with an example.  You invest Rs. one lakh upfront in Bond A which gives you a cash flow as follows:

Year 1: 25,000
Year 2: 45,000
Year 3: 50,000

There is another Bond, Bond B, where the returns on your one lakh are as follows:

Year 1: Nil
Year 2: 30,000
Year 3: 95,000

Which is the better bond to invest in? Assume that they are both equivalent on the risk scale.

Bond A gives Rs.120,000 over three years.  Bond B gives 125,000 over three years.  Bond B is better.  Hey, wait a minute!  What about time value of money?  If another Bond C yields two lakhs but after twenty years, would that make Bond C better?  We need to discount all the above cash flows to today’s terms. Let’s do that.

We have to first decide what interest rate to use for discounting.  Let’s use the long term average inflation rate, say, 7%.  The Net Present Values of the cash inflows on Bond A will be: (25,000 / (1.07)) + (45,000 / (1.07)^2) + (50,000 x (1.07)^3) = 103,484.

Bond B works out to: (0 / (1.07)) + (30,000 / (1.07)^2) + (95,000 / (1.07)^3) = 103,752

Bond B is better when you discount the cash flows to the present, but only marginally so.

What happens if we use 12% for the discounting?  Net Present Value (NPV) of Bond A works out to 93,784 and of Bond B works out to 91,535.  Bond A looks better! A change in the discounting factor could impact these calculations!  In this case, Bond B’s cashflows are backended and an increase in the discounting rate tends to decrease the values of cash flows which are farther in the future. Intuitively, you can understand why it is so. If inflation is higher, for example, your appetite for accepting the same promised return in future would be considerably diminished. Decision on which discounting factor to apply is critical in such situations – we may revisit this at a later point in time.

That’s a lot of math!  It is very important to understand how compounding works, and the impact of time on the value of money.  Hence the diversion in this issue.  A revision course in sixth and seventh standard math will help!

Bye.  Till we meet next.

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313

Part 4: There is no life without risk

From the moment you are born till the day you die, life is an unending stream of unpredictable events.  The financial sector is no different.  It throws various options at you ranging from your brother-in-law asking for a loan to the most complex financial derivative products which even the originators don’t understand.  In order to make financial decisions easier, and to be able to expose the bluff behind many tall and confusing claims, it is essential to know how to evaluate these options.  For this you need to know what are the different kinds of risks and their evaluation; evaluation of cash flows which vary in timing; concepts of present and future value, and a few other sundry stuff like that.

If this sounds like the beginning of complicated financial theory, don’t worry.  Except where absolutely necessary, in this column we shall stay out of complicated equations and needless computations.  Some amount of math is required especially relating to compound interest (as we shall see in the next issue) but not much more than that.

Understanding of Risk is fundamental to analyzing financial instruments. In the last issue we looked at “default” risk (which is also called Credit Risk) and “volatility / variability of return” risk.  Another fundamental risk is of course “physical” risk – the risk that someone will put a knife to your throat and force you to empty your safe.  Or encroach on your land. Watch Khosla Ka Ghosla to know what I mean.

What about ‘systemic’ risk?  When Kuwait was invaded by Iraq, Kuwaiti currency became worthless overnight.  The bank accounts of all Kuwaitis were inoperable; as to stock markets, even if they had existed, they would of course be shut.  In such a situation, especially when you are fleeing across the border, probably the thing that would help you the most is Gold.  Real assets like Gold and Real estate are just that – “Real” – they are held by you and are very tangible. Of course you could get mugged, or your land could be encroached upon. 

There is another kind of risk called ‘interest rate risk’.  Let’s assume you lend someone one lakh rupees and he gives you a ten-year ten-percent bond (that means he will pay you ten thousand rupees a year for the next ten years and then repay your principal – if he is still alive).  If you sell this bond to your friend after two years you expect him to give you one lakh rupees for it.  He will, provided the interest rates in the market are ruling at 10% then.  What if the new ten-year bonds in the market yield an interest of 12.5%, i.e., give an interest of rupees twelve thousand five hundred every year on one lakh of investment? He would then obviously pay you Rupees Eighty thousand for your bond – such that the rupees ten thousand interest on it works out to a yield of 12.5%. 

Thus, if interest rates go up, prices of existing bonds in the market go down; if interest rates go down, bond prices go up.  Interest Rate Risk is a fundamental principle in Finance – work out a few examples yourself so that you understand this concept well. 

Different assets have different kinds of risk profiles.  Risk is one way of evaluating an asset.  Another thing you have to be conscious of while considering an asset for investment is Liquidity.  Liquidity means nothing but how fast you can convert something to cash.  By definition, cash is the most liquid of all assets.  Bank Fixed Deposits are highly liquid since you expect to get your money out immediately subject to certain formalities.  Stocks are highly liquid.  Remember we are not talking of how much money you are taking out on selling compared to your investment, but how quickly you can take it out.  The settlement cycles on the Indian Stock Markets are highly compressed nowadays – you can get your money out in three working days.  Land is highly illiquid.  It takes a long time to sell.  Gold in any form is always highly liquid.

There are three pillars of Asset evaluation.  The first is Risk.  The second is Return.  The third is Liquidity.  Any investment that you consider must be evaluated on these three parameters.  You first need some benchmarks to start with.  Let us assume that in our case, the benchmark is the one-year FD rate of SBI which is, say, 7%.  Would you invest in Lord Yama Co-operative Bank (this is promoted by a bunch of people with shady antecendents) for a return of 9%?  You may, since the return is higher; but you need to assess whether the two percent is enough compensation for the additional risk compared to SBI.  Would you invest in Koffman Finance (promoted by an unknown group of people) at 20% per annum in a bond that is non-redeemable for five years?  In this case, the return is great but the risk is too high.  I would not.  Would you invest some money that you have kept aside for your daughter’s wedding (she is 25 now) on a plot of land?  I would not, since land is not liquid and is more of a long-term investment, and I would be hoping that my daughter at 25 would be getting married soon.  Would you invest your retirement savings fully in fixed deposits or other debt instruments (You are 25).  The returns on debt are known, they are steady, and they don’t cause sleepless nights.  For a 25-year old who is saving for retirement, the capacity to take risk should be higher than that.  You should be aiming for equity or real estate investments where the higher risk is largely mitigated in this case by the longer time period involved; but the expected returns are higher.  If I were you, in this situation, I would invest my money predominantly in a mix of equity and real estate.  Would you invest your retirement proceeds in equity (you have just retired at 60)?  That goes against the tenets of financial planning.  At the age of 60, your appetite for risk is supposed to be lower.

The more you understand and internalize the concept of Risk, the better it is. An understanding of Risk is fundamental to any financial decision.  Your own capacity to take risk is dependent on several factors including your age, current financial status, status of current investments, status and state of equanimity of spouse, your own financial goals, the certainty of holding on to your current job, etc.  Above all, your capacity to take risk is determined by your own personality. 

That was all about Risk. In the next issue, we shall look at Time Value of Money and its practical applications.  As you can see, it’s not that simple – we do need to understand some concepts and tools before getting into discussions on where to invest, etc.;  however, it’s not so difficult either! 

This is the fourth part of the series – I hope you have read the first three (available in ‘Archives’ in case you have not). Please feel free to write in your feedback now as well as at any point in time in future, along with any suggestions that you may have.  I hope you have enjoyed reading thus far.

Do write in.  Bye – till the next issue.

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.

Cheers!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313