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Published in Mint on Jun 13 2016
Every time there is a personal finance crisis, it can be easily traced to products that did not do what they were intended to do, or had no place in the individual’s portfolio given their needs and goals. While the focus of investors is always on selecting the best performing stock or bond or mutual fund, the actual emphasis should be on selecting the right product for specific needs. The wrong use may have unintended consequences on the financial situation and put your goals and needs at risk of being unmet.
Insurance for saving tax
The purpose of insurance is to provide cover from risk of loss of income, or to protect the income from a large expense or charge. But most people turn to insurance for tax benefits in the form of deductions from taxable income for the premiums paid. “The main purpose of insurance is to provide financial security and adequate cover. If you are only looking at tax, you may actually end up buying the wrong product,” said Kapil Mehta, co-founder, SecureNow Insurance Broker Pvt. Ltd.
There is little thought on whether insurance is required, what type of insurance is required, and if they are getting the best cover possible for the premiums paid. Insurance policies taken haphazardly over the years just add to costs without getting the cover you may actually need. Insurance has to be planned and needs monitored with change in circumstances.
Otherwise there is a real risk that the premiums paid are not providing adequate insurance. The financial security of the household is traded for tax benefits which are not exclusive to insurance premiums. The same tax benefits can still be availed through investments and expenses tailored to the portfolio needs of the individual.
Tax-free bonds
Tax-free bonds provide tax- free interest income. It is a useful product for investors such as retired persons, seeking regular income with tax-efficiency. Along with other features such as the long tenure, high credit quality and stable interest income, these bonds tick many boxes for retirees. However, other investors should evaluate the availability of alternative investment opportunities which may meet their needs better.
Since there is no tax payable on the income, the rate of interest on these bonds are lower than other bonds of similar tenure and credit quality. For example, if a tax-free bond paid 7% interest income, it would compare with a taxable instrument paying 7.7% pre-tax for investors in the 10% tax bracket, 8.75% for an investor in the 20% tax bracket and 10% in the 30% tax bracket. You should evaluate comparable investment options to check for better returns.
An investor in the 30% tax bracket may find these bonds attractive since finding another investment with similar risk features that pays 10% pre-tax interest is unlikely. But an investor in the 10% tax bracket is likely to find other investments with better pre-tax returns comparable to the returns from the tax-free bonds. Moreover, these bonds typically have long tenures of 15-20 years. This means that the funds will be locked-up and may not be available if liquidity is a priority. Though the bonds are listed, liquidity is typically low, and selling it may not be easy, especially if interest rates are moving up.
Equity for short-term returns
Investing in equity is expected to provide long-term appreciation in value. It requires the ability to weather short-term volatility in prices and to monitor the performance of the company. Investors should be willing to hold on to the investments even if prices fall and allow the time for the performance of the company to reflect in the prices. It goes without saying then that funds earmarked for equity investments should be those that are invested for the long term. The risk arises when investors look to equity for better returns when they do not have the ability to withstand volatility.
If the tendency is to sell and exit as soon as markets dip then losses are inevitable. Similarly, if you are investing without giving enough time for market and economic cycles to recover from a downturn, then there is a possibility that funds may have to be withdrawn when prices are low.
It may be necessary to exit an investment if performance is not as expected. These decisions can either be made by investors or with the help of advisers.
Choosing safety
Low risk, liquid investment products are suitable for preserving the principal invested in the short term and to enable drawing from a corpus created for a goal. The returns from these investments are low. They are not suitable for holding funds for the long term because money loses value over time if the returns earned do not keep pace with inflation.
“Typically for a long term investment, you should look for a little high-risk product that has the potential to give you inflation-adjusted returns,” said Surya Bhatia, a Delhi-based financial planner.
By holding investible surpluses in low-risk products even when it is required well in the future, you are under-utilising the ability of funds to earn returns.
There is a good chance that the corpus accumulated is going to fall short of the need and put goals at risk. It is possible to earn better returns by taking on some risks that are acceptable to you. Some investors may be willing to give up liquidity and invest in real estate for better returns. Other investors may be willing to take on short-term volatility for long-term gains and invest in equity.
Taking some risks for better returns protects long-term goals from being underfunded.
Choosing products for bragging rights
From teak trees to Ponzi schemes and the more regulated hedge funds and private equity (PE) funds, investors have blindly invested in products that give them bragging rights. The promise of high returns and the dubious science behind some of the products allows them to hold forth to admiring listeners.
Typically no thought goes into the risks associated with the investment or their suitability. “Remember that products with returns that are too good to be true are usually a marketing gimmick. Always understand the product well before investing,” said Bhatia. Investors in products that they have little understanding about, such as PE funds, lose money when they find that they do not have the risk taking ability or the ability to tie up funds for longer periods to generate returns.
The role that a product can play in a portfolio is defined by its risk, return and liquidity features. Holding a product in itself is not a guarantee that it is going to do what it is supposed to do. How it is used will define that. Keep it simple and manageable. Having too many products leads to duplications and rarely serves any purpose.