An investment is a monetary asset purchased with the idea that the asset will provide income or will grow in future and become wealth.
Parameters for choosing the right investment vehicle
- Risk profile
- Tax efficiency
However, majority of investors make many costly mistakes while planning and executing fund investments.
Here are some of the Common mistakes that some investors make.
- Switching from Bond Fund to FDs
In recent months, there is rise in interest rates where as there are poor returns on bonds. Owing to above facts, investors might find bank deposits more attractive and dump their bond fund in favour of bank deposits. But, the fact remains that the assured return from the bank deposits are not tax efficient. The return from fixed deposits are classified as interest income and the entire interest income of bank deposits is added to total income of the individuals and are taxed at the slab of total income. The post-tax returns will be much lower in higher tax brackets. On the contrary bond funds are more tax-efficient. If it is held for more than 3 years, then gains are treated as long term capital gains and taxed @20% with indexation benefit ie taxed on inflation adjusted returns.
- Stopping SIP when current return is reduced
This is unwise to stop SIP when the NAV is reduced because this is the time when the investor will be able to fetch more units at lower price with same SIP amount as compared to previous purchases and making optimum use of money invested.
- Starting Equity SIP for short term goals
Investor should keep at least 5 years horizon to benefit from Equity SIP since returns are likely to be muted in near term. Hence Equity SIP is not suitable for short term goal.
- Opting for Dividend scheme of Mutual fund
With 10% tax on dividend income, this proposition is no longer tax-efficient. In fact mutual fund dividend are not actually income but part of investment and gets deducted from NAV.
- Treating Insurance as investment
Most of the time, when we ask a person about their Investment portfolio, he/she invariably lands up saying that we have investments in some sort of insurance policy, ULIPs, Endowment Policy, Money Back Policy etc. Many of us understand insurance as Tax saving instrument, Investment Tool. But do we understand Insurance as Insurance? If we want to get adequate insurance with an endowment plan cover, whole of our salary will be insufficient for the it to pay the premium for the required cover. Whereas pure term plan will help in giving adequate insurance cover.
- Ignoring Inflation.
Most Indian savers, including retirees who need post retirement income, do heavy investment in bank FDs unaware of invisible evil, inflation. The real rate of return in this case will be Interest minus inflation, whereas there are mutual fund schemes such as liquid funds, ultra short term funds, which have tax adjusted return more than that of bank Fixed deposits.
- Ignoring power compounding
Compounding is the ability of an asset to generate earnings, which are then reinvested to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
Investor pays heavy cost because of delay in investing by forgoing the benefit of power of compounding.
- Investing in Direct Equity without research
When prices of equity shares fall obviously the equity mutual fund fall too. However the fall in the mutual fund NAVs is not as severe as equity shares due to diversification of stocks in the mutual funds by the fund houses. Owing to this facts investors should not buy stocks directly without research. Though investing in equity mutual is not risk-free, the risk is less than direct equity investment.
- Over diversification in investments
Diversification in investments reduce the investments risks spreading the risk across the baskets of investment vehicles. Since the market risks can not be eliminated investment above 20 stocks will not reduce the total risk. Similarly, Investing up to 8 funds focused in different segments will give adequate diversification for the portfolio. Since mutual funds replace its holdings with the winning stocks periodically, investing in more than 8 funds will only be duplication in investing thus, do not provide diversification benefits as also it is difficult to keep track of the performances to weed-out under-performers.
RIGHT INVESTING STRATEGIES
Need based investing
Reason for such investment mistakes are because investment products are not being bought and sold as per investment parameter as stated above and not even as per personalised financial need of the investor.
For example, you have Rs.20 lakhs from sale of a property and want it to invest for 10 years from now. The ideal strategy to combine adequate stability and return in the investment is to have 3 step process as below.
One– Invest entire money in a debt fund.
Two– start STP in such a way that all of it gets transferred into an equity fund over two years’ time.
Three– Start SWP on the last two year, so that the entire gradually comes back to your bank account.
Therefore, the right investment planning is to have effective investing strategy in place.
Goal based investing
First step is to identify all your goals viz very short term, short term, medium term and long term.
Second step is to calculate the amount of future value and time-frame for achieving the goals.
The final step is to choose the right investment vehicle to achieve the required goals.
Mutual fund can serve as good solution for all such investment needs with variety of options available like equity, debt and hybrid funds. Here is how you can pick fund that suits your specific requirement.
Liquid fund (up to 3 month)- for building contingency fund.
Ultra short duration (3-6 months) – for systematic transfer to equity fund.
Low duration fund (6-12 months) – for systematic withdrawal.
Arbitrage funds (1 year) – To park temporarily from equity fund for stability during high volatility in stock market.
Short term ( 1-3 years)- vacation, buying a car- debt fund/Dynamic hybrid fund).
Medium term ( 4-8 years) – buying house- balanced or hybrid fund/ Large cap).
Long term ( more than 8 years) -children education, marriage – equity oriented fund(Multi-cap/Mid Cap/ Small Cap).
Following are the exceptions to the above mentioned parameters of investing:
- Contingency fund : This is created to meet any unforeseen events such as Job loss, Medical emergencies, or urgent repairs. Here safety, liquidity is priority and not the return, Risk profile or tax efficiency. Ideally contingency fund may be equal to 6-9 months routine expenses. Liquid funds or low duration funds are best suited to to park for emergency fund since it ensures liquidity. It is better option over bank saving account since the saving bank amount may be spent easily.
- Life Insurance: A pure term plan assure the family a predetermined amount in the invent of death of the insured person to secure family. There is no survival benefit. However, in the traditional plans where insurance and investments are mixed there is neither good return nor adequate insurance cover thus defeating the purpose.
- Gold jewellery: This is the traditional form of buying gold and has got cultural value since they are compulsorily worn in social and family occasions such as marriages. Buying gold is not a bad investment, but buying it in jewellery form is a dead investment. Reasons are it costs making charges, not generally sold for cash but are exchanged for a new jewellery only after deducting wastage charges. The selling involves loss on value. This investment is not made for return and not linked to any goals. Gold bonds are best form of gold investment.
- Residential House: Investment in residential house is not meant for selling or not linked to any goals. Even if the house is sold it is normally sold for the purpose of buying a new house. The self occupied house does not generate any income and the outstanding home loan is liability.
Be wise money-wise.
Kishore Hegde, CFA (ICFAI)