Many a time people ask, “Tell me a good
mutual fund?” This question is similar to asking a doctor, “Give me a good
medicine?” How could the doctor suggest anything without knowing the problem?
Right
Answer to Wrong Question
Though the question is wrong, immoral sales people
take advantage of the gullibility and lack of knowledge of the person raising
the question to sell their products. They cannot be taken to task as well,
since they have in one way given the right answer. Problem is that the question
is wrong.
Major investment decisions have been proven
to be wrong leading to financial goals not being achieved by great margins.
Imagine a father investing for his son’s engineering education for 18 years and
falling short by 75% – where he needed 4 lakhs; he got 1 lakh!!!! The problem
was with a mix-up with respect to the asset class. He was sold a pure debt
investment when an equity based fund would have served him better.
The Questions
This article will cover most of the relevant
methods to compare investments. The idea is to arm ourselves with the right
questions so that we can get the right answers to achieve our financial goals.
The comparators used for financial investment
tools analysis are not the same for all tools. So we will in this article see
all the comparators and how they are suitable for different tools.
The Returns
Is the financial instrument / tool /
investment that give the highest return the best one? No, Not necessarily!!!!!
This is due to the fact that return has different components and their values
depend on a number of other factors too.
There are two components to returns: Current
Income and Capital Appreciation. Current
income is the regular cash flow that we get from the
investment. These are like interest from a bank deposit, dividend from a
company or mutual fund, rent from a house or commercial building. This cash
coming to us can be regular and a known quantity like a bank deposit and rent.
In case of dividends the quantum of incoming cash and time when it will be paid
out is not always known in advance.
Current income may be more important to some
people than others. A regular known income is more needed for a pensioner than
a fresher.
In most cases (except real estate, shares and
some mutual funds) the investment itself will not grow in its value when there
is a Current Income. The bank deposit of Rs.10 lakhs remains the same at the
end of the term. Even in case of a cumulative deposit, the face value of the
deposit is the same Rs.10 lakhs, the interest is the rest.
Current income is always taxed, either in our
hands (in the case of interest) or in the hands of the person paying it (in the
case of dividend).
Capital Appreciation
This is the growth in the value of the
investment itself. The land that we had bought appreciates in its value itself.
So does the share and the mutual fund bought with the “growth option”.
As with the current income, capital
appreciation is preferred by some more than the others. A young person would
want more of capital appreciation than a person nearing retirement. The issue
with any investment that can give capital appreciation is that there can also
be capital depreciation – reduction in value of the investment. So anyone with
a firm short term commitment should look to preserve the capital than look for
appreciation.
Risk
Risk is the deviation of actual returns from
the expectation. So in one way the risk that we face from any investment
depends on us (we are the ones who have the expectations). One of the measures
of risk for an investment is its variation in returns from time to time
(volatility). If the variation is high, the investment is said to be risky.
That way a bank deposit though giving lesser
returns is less risky as it has lesser variation in returns. However the risk
with bank deposits is the interest rate risk. This is so because after I made
my investment for 5 years, the bank may increase the interest rate. Or the
interest rate today is lower, so I am not able to reinvest gainfully.
The other risk is with the slowness of growth
itself. What if the capital is preserved, but the growth is lesser then
inflation. Here again we are losing the value or money. So there is no
instrument that can be called RISK
FREE. We need to choose an instrument based on our time frame
and our ability to take the risk.
Liquidity
This is the speed at which an investment
could be converted cash quickly. Gold has the highest liquidity as it can
quickly be pledged for cash. Selling gold though may not be as easy. Shares
have the next highest liquidity (2 days to cash in bank). Mutual funds come
next (1 to 3 days for liquid or equity funds).
Real estate has the least liquidity among
investments.
Tax treatment
A very important aspect to be considered when
investing is the tax treatment. Some investments today in India still enjoy
Exempt-Exempt-Exempt. This is basically getting favorable tax treatment at the
time of investment, at the time there is income and also at the time of
maturity. We are moving towards the Exempt-Exempt-Tax regime where investment
maturity proceeds will be taxed. The first to come under the EET regime is our
pension funds.
Convenience
This is the final measure for comparing
investment. Convenience is a broad heading under which the ease of
understanding the investment; ease for investment in quantum of money,
frequency of payments; specialist support to manage the investment; ease of
maintenance; etc, come up.
A mutual fund has very high convenience
factor because investments can be as low as Rs.500 per month (even lower in some
cases), has professionals who manage it, gives the advantage of
diversification, can be redeemed very easily (except those with lock-in
period). Real estate has the least convenience as it requires huge investments,
and in India has to be managed by ourselves (only very recently do we have some
professional support to manage real estate).
Summary
The article gives an overview of the
different ways in which we can compare the investments. The objective is to ask
the right questions to the sellers of products so that we get the right
answers.
Extracts from : http://www.bankbazaar.com/
