It is important to question your notions about investing options in tandem with the altering financial scape, says Uma Shashikant. Base your decisions on hard facts about risk and return, not on emotional comfort.
Source – ET Wealth – 06/02/2012We all like our comfort zones. When it comes to investing, we have grown up with some beliefs and find it tough to deal with any change. Several investors believe that a floating interest rate is not beneficial; others think that buying into longterm debt when rates are high is a great tactic; some believe that buying a home is the best way to create wealth; and many hold the view that saving taxes is better achieved by choosing short tenures. Let’s see why some of these assumptions could be wrong.
When the government modified the rate of interest on small savings products, several investors, specifically senior citizens, were upset. The commonly held view was that a fixed rate of return on popular products, such as the PPF and Senior Citizens’ Savings Scheme, was good since it gave investors a certainty of income. The problem with this view is that this certainty of income is defined in absolute cash flow terms. A fixed 8% return is good if the inflation rate is 5%, but is not enough if the rate is 10%. The fixed cash flow is a psychological comfort; in reality, the high inflation rates reduce the investor’s purchasing power.
Interest rates, at their core, are driven by expectations of inflation in the future. A lender hopes to put the money he lends today to the same use when it is returned with interest. The interest should at least cover the loss of purchasing power in the interim. A fixed rate of interest only makes an assumption about inflation. A floating rate, on the other hand, adjusts to new information about inflation. Therefore, if the investor is keen to receive a fair rate of compensation, a floating rate is a better choice than a fixed rate. For a senior citizen, who faces a compounded rate of inflation, a fixed rate that is unchanged or modified at whim is a more risky proposition.
The people who have invested in highrated debt instruments are very happy currently. They are eager to receive the promised, high fixed rate on their investments. They also believe that since interest rates are peaking now, they will be able to sell their bonds at a profit when the rates begin to fall. It is important to consider two facts. One, it takes a desperate borrower to continue to borrow for the long term at a high rate. The borrowing institution is likely to have the wherewithal to take a better interest rate call than the retail investor and distributor. Two, if everyone is a willing seller when rates begin to drop, will there be any eager buyers? If not, isn’t it likely that the secondary market will not be as liquid as expected? In investing, there is a simple rule—if something looks too good to be true, it probably is. The peaking of interest rate is also the time that credit quality begins to deteriorate and balance sheets come under pressure. The bond may lose value if its credit rating changes. If an investor manages to sell the better quality bond at a gain because rates have come down, the proceeds will be invested at the new low rate if he chooses to remain invested in debt instruments. The rate game is only a tactical opportunity and going for the new high-coupon bonds may not be a wise move. Most investors believe that if they trade the rent they pay for a home loan EMI, they will own a house. The decision to buy a house is made with the view to creating an asset. If the asset appreciates over time, there is a feeling of satisfaction. It is important to understand that home ownership is a good goal for the emotional comfort it provides. However, the financial implications have to be examined clinically. Self-occupied property does not generate any income, nor is it sold to realise capital gains. So, while investing in a house, it is important to provide the space for building other assets too. If 40% of the income goes as EMI, 40% is used up in mandatory expenses to run the house, and 20% is kept for unexpected expenses and luxuries, there is no saving. The house becomes the only big asset. Allowing space to create more varied assets over the long term is an important consideration while investing in a house. As income grows over time, the surplus should be invested in a diverse portfolio. Trying to achieve an equal allocation to property, equity and debt by the time one retires is a good goal to pursue.
At this time of the year, the dominant concern is tax. Investors like to use the money they have to save tax rather than pay it. Aggressive, and sometimes erroneous, advertisements lure investors to buy products that save tax. However, the choice of such products needs to take into account the cash flow, not the saving. If an investor makes a commitment of 1 lakh as premium to save taxes, he fails to account for a simple fact—if a saving of 30,000 makes a big difference to his cash flow, the payment of 1 lakh every year is likely to pressurise it. Many give up after making a few payments; others are misled by promises of payment for ‘only’ five years. There are others who invest in long-term products, such as taxsaving mutual funds, considering the threeyear lock-in period to be the investing term. All tax-saving schemes are long-term products. They need a longer commitment and will deliver good returns only to those who are willing to stay through cycles. Investing in them with the current year’s tax liability as the focal point might lead to an erroneous estimation of both cash outflow and inflow in subsequent years.
It is a good habit to question popular assumptions and notions from time to time. Take into account the changes that take place in the investing world and reformat your strategy accordingly. The investing world is a cold one featuring hard facts on risk and return. No product is created with the objective of making people rich and wealthy without any accompanying pain.
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