Money - A Friend in Need is a Friend Indeed (Part 1)

Oh No, Not Again

I know you would have read a lot of information about how to invest wisely - both offline and online; and that this topic might sound clichéd to many readers (I am feeling it while writing, so I am sure you would also harbour the same feelings as you read on). But trust me,a lot of information is available these days, and the trick lies in correct perception, understanding and application of relevant things which impact you. Having done my MBA in Finance, I have been tempted a lot of times to write something related to financial advisory. So, today goes my first post in this series. A lot from this article is derived from my own personal experiences. I have taken uninformed decisions in the past; I want others reading this blog to take better decisions than I did.

Needs Vary with Time

I believe that as we grow, get older and pass through different phases of life, our needs change with respect to the phase of life we are in. After passing out from college, having got the first job and experiencing financial independence for the first time in life, one hardly thinks about how much one is spending, where one is spending, how much should one save, how much and where should money be invested and the likes. This generally involves youngsters in age group of 21-26 years old, and this is the target segment for most of the businesses dealing with financial investments- be it mutual fund, insurance, ULIPS etc etc. The rationale for these companies is simple - youngsters generally don't have much experience with finance and have lots of money with them (especially during the months of November to February,w.r.t India especially, when we suddenly get a jolt from our fairy-tale lifestyle and think of our 1 lac of investment for tax saving purpose.)Hence, my article is especially dedicated to this segment.

Investopedia

One can have the following Investment Options (The list is not exhaustive):

1. Mutual Fund
2. Life Insurance
3. Health Insurance
4. Public Provident Fund (PPF)
5. ULIPS (I'll tell later why this is a bad option)
6. Infrastructure Bonds

Now, there is an obvious question: what amount should I be investing in which instrument? Many people are quite puzzled and confused with this question. I have seen people, after retirement, investing > 90% of their savings in Equity Linked Mutual Funds; while some stock broking houses target such people and invest their money directly into stock markets. I fail to understand the logic behind this, as retired people don’t even have a regular source of income. Hence, it would be difficult for them to absorb any losses that arise due to this decision.

The answer to the above question is very simple -> If your age is X, and your total investment amount is Y, then

• Investment in Equity = (100 - X)*Y/100
• Investment in Debt = X*100/Y

 Hence, suppose if one is 25 years old and has 1 lac to invest, that person should be investing 75,000 into Equity Instruments and 25,000 into Debt Instruments. The above equation helps you to decrease your exposure in Equity instruments, which have high risk and high return, as your age increases. Thus, as the risk bearing capacity of a person decreases with age (and hence, due to the different phases of life - marriage, kids, kids' education etc), his exposure to Debt instruments, also known as Fixed Income instruments, increases.

In this article, my focus would be on the Mutual Funds. In my subsequent articles, I'd throw more light on the other investment instruments listed above.

What’s in Here for Me??

Do these questions sound familiar?

Should I invest directly in Stock Market or in Mutual Funds?

In my opinion, and as suggested by the great Mr. Jhunjhunwalla, it is best to invest in Mutual Funds than in direct stock market, because of the following reasons:

1. The Mutual Fund houses have dedicated and qualified people who do the research about various companies, and then churn the portfolio accordingly, in order to keep in line with the investment focus of a particular mutual fund scheme, and give you the desired returns.
2. One doesn't have to glue himself to the stock broking websites all the time, and keep on looking for opportunities to buy/sell one's shared.
3. The portfolio maintained by the mutual fund houses are much more diversified than the portfolio of stocks that one holds. Many a times, due to inappropriate amount of diversification in the stock portfolio of individuals, they gain/lose more than the Sensex.

Should I invest in a New Fund Offer (NFO) or an Existing Scheme?

This is a very common misconception amongst the investors that they would be gaining more by investing in NFOs. This is because one thinks that one would be able to buy more units of the NFO, and more units translate to more profit, which is absolutely wrong. 

For eg, let's say one has 10,000 for investment. There is an NFO in which 1 unit is priced at 10/-. There is another scheme, say MF, that has been in market for 5 years now, and its 1 unit costs 100/-

No of units bought if invested in NFO - 1000

No of units if invested in MF - 100

Now, suppose after a year, the MF gives 15% returns, whereas the NFO gives 12% returns. Hence, a unit of NFO would now be valued at roughly 11.2/-, and that of MF would be valued at roughly 115. Hence, after a year

Value of Investment in NFO = 1000 * 11.2 = 11,200

Value of investment in MF = 100 * 115 = 11,500

Hence, the same amount of money (10,000/-) amounts more when invested in MF than in NFO. Of course, if you have reasons to believe that the portfolio of NFO is much stronger than that of MF, and has potential to generate more returns than NFO, one should go for the NFO. But, for taking this decision, one should have a good know how of finance.

Which Scheme should I invest in?

There are a plethora of schemes available in the market. The scheme in which you want to invest depends on your financial goal. If your goal is to save tax, then go for tax-saving schemes; if your objective is to generate wealth, then go for other schemes available in the market. In the tax saving ELSS schemes, there is a lock-in period of 3 years, whereas there is no such lock-in period in other schemes. Hence, once you have invested in a tax saving scheme and it’s not performing well, you can't do much about it for 3 years; the same is not true for other schemes though. Moreover, many of the non tax saving schemes in the market are giving much more returns as compared to the tax saving schemes. Hence, it's totally a call of an individual as to what one wants to do.

While selecting a scheme, keep in mind the following 2 points:

• The scheme that you select should be giving a consistent performance in the past 3-5 years. If a scheme is in top 5 schemes based on  5-yearly, 3-yearly and 2-yearly returns, short list that scheme.  
• This is one of the most important thing that people generally ignore. The returns of the scheme that you have shortlisted should also be greater than the returns of the Benchmark index that the scheme refers to, or at least the Nifty/Sensex. If you apply this criterion, you would be surprised that the short list that you arrived at in the first step would further get shortened. :)

The rationale behind the last point is that if the portfolio of shares maintained by the mutual fund scheme is not able to give more returns compared to the portfolio of shares used in calculation of Nifty/Sensex, then you are not gaining anything. You can easily get as much returns as the Nifty/Sensex, because their portfolio of shares is easily available to the general public. Hence, the logic.

The mutual funds that invest in large cap stocks are most secure, followed by mid-cap stocks, small cap stocks and sectoral stocks. Hence, the returns provided by these follows a reverse order,i.e, max in sectoral/small cap funds and min in large cap funds. This is because the small cap stocks are the most volatile and large cap stocks are least volatile. Thus, gains/losses in case of small cap stocks are much more than the large-cap stocks, when compared to the gains/losses in Sensex.

Conclusion

Watch out for the continuation of this series, for information on the other investment products. I hope the information in this article would help you in taking more informed decisions when it comes to choosing your Mutual Fund. All the Best!!