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Anand

Saturday, May 23, 2009

Laddering



Laddering is an effective investment technique that is used by many intelligent investors who want to put their money to best possible use. You can do a Ladder using many investment options like Bank FD, NSC Certificates, Bonds etc.

Just like a normal ladder, our investment ladder also has a certain number of steps. This is determined by the initial number of investments that we would be ready to make. Let us take an example where a Bank FD ladder is formed by Mr. X.



Let us say Mr. X has idle cash of Rs. 3 lakhs and is willing to deposit it in a bank to ensure safety of the capital. Let us say the bank offers him an interest of 8% for one year and Mr. X invests it happily. At the end of the first year Mr. X would get Rs. 24,000/- as interest. Now if Mr. X wants to invest in the bank FD again, there is no guarantee that the bank would offer 8% or more. Based on the market interest rates, the bank may opt to reduce it. Let us say the bank reduces the rates to 6%, Mr. X has effectively lost Rs. 6,000/- that year as interest income. This is called Re-investment Risk.

Laddering is a technique that can help us reduce this risk to a great extent. You can limit reinvestment risk by laddering, since you'll only have to reinvest part of your total fixed-income assets at any one time.

A FD ladder is made up by purchasing several FD's at one time with different maturity dates. One example of a FD ladder is to have maturity dates of one year, two years and three years. These three investments make up the three rungs of your FD ladder with one certificate maturing every year for the next Three years.

Mr. X had Rs. 3 lakhs to invest. He would buy 3 FD's for Rs. 1 lakh each with each one invested for one year more than the first. So he would have a 1 lakh FD maturing in one year, another in two years, and so on up to the last one which matures in Three years. Every year for the next three years one of his FD matures and earns you interest on his principal of 1 lakh.

When the deposit matures, he would roll it over into another FD. The best strategy is to purchase a new CD at the longest term, which in our example above would be three years. This strategy allows you to take advantage of the higher rates normally associated with longer-term FDs while maintaining more frequent access to part of your funds.

Let us say Mr. X needs Rs. 50,000/- at the end of the 6 months and he has no other cash sources apart from his FD’s. In the normal scenario, he would have had to pre-close his FD (which would attract a penalty & he would not get the normal Interest) and then re-invest the remaining money in a different FD which may or may not earn as much as the interest rates may have changed. But in our scenario, all Mr. X would need to do is, take Rs. 50,000/- from one of his FD’s and let the remaining 2 FD’s go on as planned thereby reducing the penalty and interest lost because of the unexpected emergency.

Another advantage to laddering your FD's is that over time it evens out the high and low interest rate cycles. Some years interest rates will be high, other years the rates will be lower. Currently banks are paying some of the highest FD rates we've seen in the last decade.

Before deciding on laddering your FD's, make sure you can afford to do without that money for a period of time. You'll pay a penalty for withdrawing your funds before your FD reaches maturity.

Also, don't get stuck on the idea that you have to invest in a 3-year ladder. You may be more comfortable with a five year ladder based on your financial needs. Or you may want to try a ladder with a 3 month, a 6 month, a 12 month, and a 24 month maturity. You can try a NSC ladder with 6 steps where you begin by buying NSC certificates every year for the next 6 years and then continue to Ladder it during subsequent years.

The benefits of laddering your FD investment is that you lower your risk of losing money when rates are low, increase your returns when rates are high, and still have access to a portion of your money, should you need it for an emergency.

Happy Investing!!!

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