Tuesday, December 30, 2008

Gold as an Investment

The concept of buying/holding Gold has been followed for ages. Gold has been one of the most sought after precious metals for generations and people have been crazy about owning gold always. In olden days the amount of gold possessed by a king signified his power. In the modern times the amount of gold in the reserves signifies the strength of a country's economy. It is an unsaid truth that Gold symbolizes wealth.

Gold as an Investment option is very attractive. When I was in my school my mom used to buy 10 grams of gold at the price I get her 1 gram now. That is how much the price of gold has gone up in the past 10 years. Also, gold is a limited resource. In India especially we do not have many gold mines that have been able to consistently produce as much gold as some nations around the world are producing. So considering these 2 factors Gold is a very attractive and a comparatively safe investment option.

What kind of returns you can expect from Gold?

The typical returns from Gold would range from somewhere around 10% or even more year on year. The amount of increase in the price may vary based on a variety of reasons but the consistent upswing in the gold prices is happening for years and would continue. Also it is a safe investment option where your gold is worth as much as the price of gold in the international market. It is not as risky as the stock market and hence the risk of holding gold is very minimal.

What affects Gold prices?

The price of gold is ultimately driven by the Supply & Demand theory. When the demand for gold exceeds the supply the price goes up. Yearly 2500 tonnes of gold is mined all around the world and the demand for gold is approximately 3500 tonnes. This means the demand for gold is a 1000 tonnes more than what is being mined all over the world. This translates into a steady increase in demand as well as the price of gold.

In general gold becomes a very favorable investment option during some situations like Economic Crisis, Depression, Recession etc. During these periods the returns on investment on other forms of investments like Stocks, Mutual funds, Real estate etc is negative. During such times the demand for gold goes up heavily. People take out their investment in other avenues out of fear of loss and invest into safer avenues like Gold or bank deposits. This causes the price of gold to go up drastically. The price of gold per 10 grams has gone up by nearly Rs. 1000/- in the last 6 months.

Methods of Investing in Gold:

The various methods in which one can invest in Gold are:

1. Bars

The most traditional way of investing in gold is by buying bullion gold bars. In some countries, like Argentina, Austria, Liechtenstein and Switzerland, these can easily be bought or sold "over the counter" of the major banks. Alternatively, there are bullion dealers which provide the same service. Bars are available in various sizes, for example in Europe these would typically be in 12.5kg or 1kg bars, although many other weights exist, such as the Tael, 10oz, 1oz bar, 10g, or 1 Tola.

Gold bars can be held either directly (i.e. held directly by you or in your own safe) or indirectly (held in a vault on your behalf). Banks in Switzerland offer this service of holding gold in Vaults on your behalf.

2. Coins

The most common way of investing in gold is by buying gold coins. These coins are available in jewelery shops all over the country. They come in weight ranges starting from 1 gram and are usually in the sizes of 1g, 2g, 4g, 8g. This is ornamental 22 Karat gold that is bought and sold at the price of gold in the international market.

Of late many banks in India are selling gold coins with certificates of purity and genuineness.

Note: The coins sold by banks are 24 Karat gold. They are sold at a premium when compared to the market price of gold because of the cost involved in packaging and certification of the gold. Most importantly banks would not buy back these gold coins. You would have to sell them at the nearest jewelery shop. You might lose a little money in this selling process.

3. Exchange Traded Funds

Exchange Traded Funds are the latest means of investing in Gold. Gold exchange-traded funds (or GETFs) are traded like shares on the major stock exchanges including London, New York and Sydney. The first gold ETF, Gold Bullion Securities (ticker symbol "GOLD"), was lunched in March 2003 on the Australian Stock Exchange, and originally represented exactly one-tenth of an ounce of gold. Due to costs, the amount of gold in each certificate is now slightly less. They are fully backed by gold which is both deposited and insured. The inventory of gold is managed by buying and selling gold on the open market.

Many investors who wish to hold gold on a long term basis find the Exchange Traded Fund method to be expensive as annual costs can range from 0.40% to 0.50%. For investors holding gold over the long term these costs add up. The major difficulty is that the costs are deducted as a reduction in physical bullion held. Thus the investor not only pays each year but loses the future performance of the bullion that has been deducted.

Gold ETFs represent an easy way to gain exposure to the gold price, without the inconvenience of storing physical bars. Typically a small commission is charged for trading in gold ETFs and a small annual storage fee is charged. The annual expenses of the fund such as storage, insurance, and management fees are charged by selling a small amount of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time. Economies of scale, liquidity, and ease of purchase and sale make ETFs an increasingly popular method of investing in gold.

Benefits of Investing via Gold ETF's

1. You can buy quantities as small as 1 gram
2. You can buy them at the convenience of your home/office. All you need is a system with an internet connection and a valid DEMAT account
3. You need not bother about safeguarding your gold. The ETF provider takes care of it
4. You can sell it on any working day when the markets are open

UTI Gold Exchange Traded Fund

On 17 April 2007 UTI Mutual Fund listed Gold Exchange Traded Fund (NSE: GOLDSHARE) on the National Stock Exchange of India. The objective of UTI Gold Exchange Traded Fund is to endeavor to provide returns that, before expenses, closely track the performance and yield of Gold. Every unit of UTI Gold Exchange Traded Fund approximately represents one gram of pure gold. Units allotted under the scheme will be credited to investors’ demat accounts.

Furthermore, there are many more ETF's HDFC Gold ETF, ICICI Gold ETF, Benchmark GoldBees etc are gold based ETFs that invest in gold and can be bought and sold as shares.

Happy Investing...

Sunday, December 21, 2008

Insurance & Indian Income Tax

Life insurance is the least understood of all financial products. While the basic purpose of insurance is to protect the dependents of the insured from financial distress in the event of his/her death, it is usually bought as a tax saving tool or an investment option.

People often confuse investment and insurance and I had elaborated about the same in my article on Insurance. To read more Click Here

This article is about the conditions that need to be considered before taking an insurance policy for tax saving.

All of us know that insurance policies give us tax exemption under sec 80C of the Indian Tax laws but not all policies or rather not the entire amount of insurance premium is exempt from income tax.

Income tax comes into play at 2 points during the term of your insurance policy.

1. At the time of buying the policy (The tax benefits on the premium paid)
2. When you receive the policy proceeds at the end of the policy term

You may be wondering by now, I know that my entire premium is eligible for tax deduction as long as it is less than 1 lac. Well thats not the case. There is a catch here which not many of us know.

The deduction is allowed only if the premium is less than 20% of the insurance cover. For example if you take a policy for Rs. 1,00,000/- and your premium is Rs. 30,000/- per annum then only Rs. 20,000/- is eligible for tax purposes. The tax deduction also requires you to be bound to the policy for atleast 3 years to get the tax benefit. If you terminate your policy within 3 years, the tax deduction that you availed is withdrawn and that amount would be a taxable income and you would have to pay tax on it.

There are other tax rules that you should be aware of, especially if you take a single premium plan. If the insurance is terminated within 2 years in case of a single premium policy, the tax deduction allowed earlier is taxable as income.

Lastly, there is some good news for all of us. Any sum received by a policyholder (You) on maturity is totally tax free. (for normal insurance policies)

If you have a pension plan and are receiving your maturity amount, only 33% of the total corpus is tax free. The balance is taxable and you need to pay tax on the same that year.

Happy Insuring yourself...

Monday, December 1, 2008

Fixed Maturity Plans - FMP's

Of late people have been talking a lot about Fixed Maturity Plans and how they are better than bank FD's etc. This article is an attempt to introduce you to this investment option.

What are fixed maturity plans?

FMP's, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a little bit of difference. Fixed maturity plans are investment schemes floated by mutual funds and are close-ended with a maturity period ranging from three months to five years. These plans are predominantly debt-oriented, while some of them may have a small equity component.

The objective of such a scheme is to generate steady returns over a fixed-maturity period and immunizing the investor against market fluctuations.

The maturity amount of a fixed deposit in a bank is 'guaranteed', whereas it is only 'indicated' in the FMP of a mutual fund. The regulator for FMP's does not allow fund companies to guarantee returns, and hence they declare only 'indicated returns' in FMPs.

Typically, the fund house fixes a 'target amount' for a scheme, which it ties up informally with borrowers before the scheme opens. . Since the fund house knows the interest rate that it will earn on its investments, it can provide 'indicative returns' to investors.

How does a FMP work?

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment.

These FMP NFOs are generally open for 2 to 3 days and are marketed to corporates and high net-worth individuals. Nevertheless, the minimum investment is usually Rs 5,000 and so a retail investor can comfortably invest too.

FMPs usually invest in certificate of deposits (CDs), commercial papers (CPs), money market instruments, corporate bonds and sometimes even in bank fixed deposits.

Depending on the tenure of the FMP, the fund manager invests in a combination of the above-mentioned instruments of similar maturity. Say if the FMP is for a year, then the fund manager invests in instruments that would be maturing in one year.

The prevalent yield minus the expense ratio, which varies from 0.25 to 1 per cent, will be the indicative return which can be expected from the FMP. The expense ratio is mentioned in the offer document. The yield can be indicated fairly accurately because these schemes are open only for a short while.

The fund received is for a pre-specified tenure and the exit load from this plan is high (usually 1 per cent to 3 per cent, depending on the time of redemption). So, the fund manager has the liberty to deploy most of the funds mobilized under the scheme as per his investment decision.

The actual return can vary slightly, if at all, from the indicated return. Against that, a bank fixed deposit exactly prints the amount which is due to you on maturity on the FD receipt. However, FMPs do earn better returns than fixed deposits of similar tenure.

Since FMP's and Bank deposits both invest in debt products the returns earned would be more or less similar. But the FMP's always earn a better return than a Bank deposit. Let us find out how...

The difference maker is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

* Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.
* Long-term capital gains (investment of more than a year) enjoy indexation benefit.
* Short-term capital gains are added to the income of the investor and taxed as per his/her slab, whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

The results of all these are quite dramatic.

Let us take an example of a 90 Day FD with a returns of 8% compared to an FMP (Both Growth & Dividend) at the same 8% per annum for an investor who is in the highest tax bracket in India.

Bank FD FMP - Dividend option FMP - Growth option
Yield 8% 8% 8%
Tax 33.66% NIL 33.66%
DDT NIL 14.025% NIL
Net Yield 5.3% 6.8% 5.3%

Actually, the dividend distribution tax is deducted on the gross yield. So the return from the dividend option can be 10-20 bps higher.

But for the sake of simplicity, it is calculated here on net yield. If the tenure of the FMP is more than a year, the growth option gives a higher yield because of the indexation benefit.

What is indexation benefit?

Our minister has been generous enough to recognise that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation. The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.

A 30 month Bank FD would give us a post tax return of 5.5% whereas a 30 month FMP with indexation benefit would give us approximately 7.7%.

Note: If your investment horizon is short (3 - 6 months) then opt for Dividend option of FMP. If your investment horizon is long (> 1 year) then opt for Growth option to enjoy the indexation benefit.

Factors influencing decision to invest in a FMP

The following are the key factors which an investor must look at before investing in FMPs.

1. Cash flow forecasting: FMPs are suitable for investors who require locking in funds for a particular period of time. E.g. If an individual has a certain cash outflow in three years time, investing in a debt FMP with three year maturity can be considered as the investor is only concerned with receiving the principal plus return on the investment at the end of three years.

2. Immunization of investments: FMPs are a good investment vehicle for investors who are targeting a return on their investments over a fixed period of time and are indifferent to market volatility within that period.

3. Interest rates currently prevailing in the market: The investor should look at interest rates on government bonds, corporate bonds, commercial papers, certificate of deposits, securitised assets, bank deposits, company deposits and other short to medium term fixed income products before taking an investment decision in a FMP. This exercise will give an idea to the investor on the return one can expect on FMPs.

You may be wondering why not so many people are investing in FMP's. All good things have their risks too. FMP's do not come with '0' RISK like the Bank deposits do.

Risks involved in Investing in FMPs

The close ended nature of FMPs does not really protect them against risks including market, credit and liquidity risks. FMPs have the potential for capital depreciation. Investors should take a closer look at the risks in FMPs before making an investment decision. The risks in FMPs are elaborated below.

1. Market risk: Market risk in an FMP is high where there is an equity component in the plan. The fixed maturity nature of the FMP, forces the fund manager to take shorter term calls on equities. This can lead to trading losses as the fund manager does not have the luxury of time to hold on to the investments.

2. Interest rate risk: FMPs are designed to immunize investor against interest rate risk. However, as a plan is launched and money is collected, interest rates can fall before the money is invested and the funds will have to be invested at a lower rate. In such a case the Fund manager may not be able to meet the indicated returns that was declared during the NFO. The non availability of a forward rate market in India is a chief contributor to interest rate risk in a FMP.

3. Gapping risk: If the fund manager is unable to find assets exactly maturing with the plan, this leads to a risk of asset liability mismatch. This risk can negate the immunization of the investment. That is, funds can lie idle with the fund house thereby earning no returns which in turn erodes the final return.

4. Credit risk: Since the FMP's invest in company deposits, the returns on such investment is not guaranteed. Lets assume our FMP invests 10% of its corpus in ABC Ltd and the company declares bankruptcy before the due date, then the amount due from them is wiped off. The fund house would have to manage without this corpus which would eat out on the net returns of the FMP.

5. Terms for large investors: Investors will have to watch out for terms on large investors i.e., if large investors are given zero or low exit loads. This can lead to early exit by large investors from the plan. This will affect the returns on the plan substantially.

Carrying out the above suggested due diligence on a FMP can protect investors from heart aches on wrong decision on FMP investments. FMPs are illiquid and investments can be only liquidated in specific periods. During periods where redemption is allowed, markets may have moved adversely leading to capital loss on liquidation. The load barriers are also quite heavy to prevent pre-mature withdrawals.

So think twice before investing in FMP's. They are not suitable for everyone.

Happy Investing...

Tuesday, November 18, 2008

Balanced Portfolio

A Balanced Portfolio is one that is designed to take care of capital preservation to an extent and at the same time to generate decent returns when compared to a Conservative Portfolio. A conservative portfolio can give a return of around 10% per annum and it may go up or down based on the returns generated by the 25% equity component. Otherwise our capital that we invested in it would remain almost intact. In a Balanced Portfolio we would invest around 50% in equities and the remaining 50% in safe investments like in the conservative portfolio.

A Balanced portfolio is ideal for people who are ready to take a medium risk by investing in stock market and at the same don't want to expose themselves to too much risk.

In a Balanced portfolio since half of our money is invested in safe instruments, even if the markets crash atleast half of our money would be safe. The equity exposure would give us decent total returns on our investment.

Pls refer to the Conservative Portfolio to find out the instruments that can be used for the safe investment part.
Pls refer to the Aggressive Portfolio to find out the instruments that can be used for the equity investment part.

A Sample Balanced Portfolio:

Direct Share investment - 10% -> Rs. 10,000/-

This amount can be directly invested in Large Cap stocks that have been growing at a consistent pace over the year. Pls check the article on criteria to be considered before choosing stocks so that you can choose good stocks for your portfolio.

Do not invest the whole amount at one shot. Buy in a phased manner. Say for e.g., buy shares worth Rs. 5,000 every 6 months

A Systematic Investment Plan (SIP) in a Diversified Equity Mutual fund for Rs. 2000/- per month which is Rs. 24,000/- per annum
A SIP in an ELSS Mutual fund for Rs. 1500/- per month which is Rs. 18,000/- per annum

Investing the SIP way is the best way to invest in Mutual funds because they average out the cost of purchase because we keep buying even when the market is down.

Gold - 10% -> Rs, 10,000/-

Bank Fixed Deposit - 20% - Rs. 20,000/-
PPF - 20% - Rs. 20,000/

Net amount invested = Rs. 1,02,000/-

What Returns can you Expect out of this portfolio?

As we know, PPF & PPF give us a return of 8% per annum and Banks give us returns of upto 10% per annum. We will assume that gold would give us a 15% return per annum. Lets say the Shares gave us a returns of 25% this year and the Diversified Equity fund a return of 30% and our ELSS fund a return of 23%.

Value of Shares at the end of one year - Rs. 12,500/-
Diversified Equity MF Value at the end of one year - Rs. 31,200/-
ELSS MF value at the end of one year - Rs. 22,140/-

Value of Gold at the end of one year - Rs. 11,500/-

Amount in Bank FD at the end of one year - Rs. 22,000/-
Amount in PPF at the end of one year - Rs. 21,600/-

Net portfolio worth at the end of one year = 1,20,940/-

Returns on Investment = 18.5%

Happy Investing...

Aggressive Portfolio

An aggressive portfolio is designed with the motive of earning high returns on our investment. This is suitable only for high risk investors for whom capital preservation is not a priority. They are ready to take the risk to ensure that their money is growing at a rate that far outpaces inflation.

An aggressive portfolio is one that has exposure to equity related components to the level of at least 70% or more. The remaining portion is invested in safe instruments like bank deposits, NSC, PPF etc. To check out the safe instruments available for investment check out the article on Conservative Portfolio.

Why is the Aggressive Portfolio High Risk?

Since we are investing at least 70% of our portfolio in Market related instruments the aggressive portfolio is considered high risk. The Market may go up or down based on the global economic conditions. We cannot always predict the direction of movement of the market. Under th current economic scenario, the market is going down drastically and a lot of people who have invested their money in market related instruments have lost a bulk of their investment. Hence investing in the aggressive portfolio would involve taking a huge risk which may not be apt for everybody.

Instruments that can be considered for the Equity component:

1. Equity Shares - If you watch any news channel or listen to any of your colleagues talking you would have invariably heard the term "Shares". The term shares used here refers to "Equity Shares". "Equity Shares" are the most common types of shares and are the most widely traded stock market instruments.

"Equity" means ownership. Anyone who holds one share of XYZ company owns a portion of the company. To know more about what equity shares are click here

2. Mutual Funds - A Mutual Fund is nothing but a common pool of money collected from a lot of people which is used by an experienced fund manager who invests the money in the Share market. Not many of us are experienced in investing directly in the Equity market. Mutual funds are a boon to the investor who doesn't have enough knowledge to invest directly in the market but wants to take a risk and gain higher returns from the market. To know more about mutual funds click here

You can invest in Diversified Equity MF's or ELSS MF's or even Sector specific MF's.

A Sample Aggressive Portfolio:

This portfolio is for somebody who can invest Rs. 1 lac every year. You can adjust the amounts according to the amount you can invest.

Direct Share investment - 30% -> Rs. 25,000/-

This amount can be directly invested in Large Cap stocks that have been growing at a consistent pace over the year. Pls check the article on criteria to be considered before choosing stocks so that you can choose good stocks for your portfolio.

Do not invest the whole amount at one shot. Buy in a phased manner. Say for e.g., buy shares worth Rs. 5,000 every alternate month.

A Systematic Investment Plan (SIP) in a Diversified Equity Mutual fund for Rs. 2000/- per month which is Rs. 24,000/- per annum
A SIP in an ELSS Mutual fund for Rs. 2000/- per month which is Rs. 24,000/- per annum

Investing the SIP way is the best way to invest in Mutual funds because they average out the cost of purchase because we keep buying even when the maket is down.

Gold - 5% -> Rs, 5,000/-
Bank Fixed Deposits - 20% -> Rs. 20,000/-

Net amount invested = Rs. 98,000/-

What Returns can you Expect out of this portfolio?

Usually the returns of an aggressive portfolio would be exceptional during bull markets and the losses we suffer may also be extensive in case of economic crisis.

Lets say the Shares gave us a returns of 25% this year and the Diversified Equity fund a return of 30% and our ELSS fund a return of 23%. Gold a return of 15% and Bank Deposit a return of 10%

Share value at the end of one year - Rs. 32,500/-
Diversified Equity MF Value at the end of one year - Rs. 31,200/-
ELSS MF value at the end of one year - Rs. 29,520/-

Gold value at the end of one year - Rs. 5,750/-

Bank FD amount at the end of one year - Rs. 22,000/-

Net portfolio worth = 1,20,970/-

Returns on investment = 23.4%

Happy Investing...

Conservative Portfolio

A conservative portfolio is one in which our main aim is capital protection. The gains may be small but the capital we invested would not erode in value. That is the reason why 75% or even more of the portfolio is invested in safe instruments. Only the remaining is invested in moderate risk to high risk instruments.

Let us have a look at some of the instruments that we can consider as safe investments:

1. Bank Fixed Deposits
a. Very Safe
b. Highly Liquid
c. Gives you a decent rate of returns (Upto 10% these days per year)

2. PPF - Public Provident Fund
a. Very Safe
b. Useful for long term investment because your money is locked in for 15 years
c. Gives you a decent rate of returns of 8% per annum which is compounded every year

3. NSC - National Savings Certificate
a. Very Safe
b. Useful for medium term investment because your money is locked in for 6 years
c. Gives you a decent rate of returns of 8% per annum which is compounded every half year

To know more about the Bank fixed deposits or PPF or NSC check out the article on Investing to Save Tax.

4. Gold
a. Very safe (You will possess the gold so nobody can deny money if you want to sell it)
b. Moderately Liquid - You need to find a buyer to convert your gold to cash

The specialty of Gold is the fact that, it may give you returns of as high as 20% per year but this is not a guaranteed return. It may go up or even go down. The only advantage of gold is that it is a precious metal which is under demand always and you can expect the prices to go up constantly. Since it has a small risk attached with it, make sure that your exposure to gold does not exceed 10% of your portfolio's net worth.

A Sample Conservative Portfolio:

This portfolio is for somebody who can invest Rs. 1 lac every year. You can adjust the amounts according to the amount you can invest.

PPF - 25% -> Rs. 25,000/- per year
Bank Fixed Deposits - 20% -> Rs. 20,000/- per year
NSC - 20% -> Rs. 20,000/- per year
Gold - 10% -> Rs. 10,000/- per year

Open a Systematic Investment Plan with a Diversified Equity fund or well managed ELSS fund for Rs. 2,000/- every month. Investing the SIP way is the best way to invest in Mutual funds because they average out the cost of purchase because we keep buying even when the maket is down.

Equity SIP - 25% (2,000 pm * 12 -> Rs. 24,000/-)

Net Total - Rs. 99,000/-

Stay away from direct Equity exposure.

Reason: Equity investment requires a lot of planning and careful stock selection and most importantly it involves a lot of risk. You are wondering by now that I have suggested a SIP in a Equity oriented mutual fund. That is because, Mutual funds are managed by professional fund managers who have a lot of expertise and time to manage the fund. Since we are going with a conservative portfolio it is better we avoid direct stock investments.

What Returns can you Expect out of this portfolio?

As we know, NSC & PPF give us a return of 8% per annum and Banks give us returns of upto 10% per annum. We will assume that gold would give us a 15% return per annum and the Equity SIP gives us a nominal 20% returns per annum.

PPF Amount at the end of one year - Rs. 27,000/-
Bank FD Amount at the end of one year - Rs. 21,800/-
NSC Amount at the end of one year - Rs. 21,632/-
Gold Value at the end of one year - Rs. 11,500/-

Equity SIP Value at the end of one year - Rs. 28,800/-

Net Portfolio Worth - 1,10,732/-
Amount Invested - Rs. 99,000/-

Returns on Investment = 11.85%

Happy Investing...

Friday, November 14, 2008

Investment Portfolio

A Portfolio is nothing but the collection of investment instruments held by an individual or a company.

For e.g., An investment portfolio may include shares, mutual funds, gold, bank deposits etc.

Why do we need a Portfolio?

A portfolio is formed with an investment objective & investment horizon in mind and with an expected rate of returns. The investment horizon may range from a few months to even a few decades. The rate of returns would vary based on the individuals risk taking ability. Say for e.g., you may want to save up money for your retirement. In such a case your investment objective would be Retirement and investment horizon would be 20 years. A portfolio needs to be carefully planned and monitored constantly to ensure that our investment objectives are met within our investment horizon.

Risk Tolerance

Your Risk Tolerance is something that determines the instruments to be considered in your investment portfolio. Not everyone has the same risk tolerance level. If you are single and earning a handsome salary with no financial dependents, then your risk tolerance level is very high. If you are married and you have a wife and child dependent on you then your risk tolerance level is medium. If you are going to retire and would have to safe guard the money that you have saved so far then your risk tolerance level will be low.

Risk tolerance determines the instruments considered in your portfolio. A high risk investor may expose his portfolio heavily with equity products whereas a risk averse investor may expose his portfolio only to debt or other safe investment options.

Based on your risk tolerance level we can form 3 basic kinds of portfolios.

1. Aggressive Portfolio - For individuals with high risk tolerance
2. Balanced Portfolio - For individuals with average risk tolerance
3. Conservative Portfolio - For individuals with low risk tolerance

You have to decide in which category you would fall into. It is not mandatory to choose only these 3 portfolio's. You can opt to be somewhere between an aggressive and balanced portfolio wherein your investments would neither fall under aggressive category nor would they fall under balanced.

Your investment objective & horizon and risk taking ability would determine the kind of portfolio that would suit you.

Let us talk about the specialties of each portfolio and then we will try to form a portfolio for each category.

Aggressive Portfolio:

An aggressive portfolio is one that is designed to give us returns of at least 25-30% per annum. To provide such staggering returns we must have an extensive exposure to Equities (The Stock Market instruments - Shares & Mutual Funds) Equities have been able to provide a returns of around 30% or even more year after year. An ideal aggressive portfolio would invest about 70% of its portfolio worth in Equity related instruments. The remaining 30% would be invested in Debt instruments (Bank deposits, Bonds etc) & Gold.


1. We can expect good returns on investment - at least 25% to 30% every year
2. If we begin early, then the power of compounding would work out in our favor and we would be sitting on a large saving when we are due for retirement


1. Since the equity exposure is around 75% the risk on investment is very high.

With the current market scenario people are not so confident about investing in equities. But this market slowdown is only temporary. In a few months time, the market would be back on its feet and once again equities would be providing us with the kind of returns that it has been providing us so far.

To know how to form an Aggressive Portfolio Click Here.

Note: In the current market scenario, expecting short term gains is not wise. Shares of some of India's greatest companies are available at great valuations. If we buy them now and build a solid portfolio, we are sure to make decent gains once the market is back to its bullish ways.

Balanced Portfolio:

A balanced portfolio is one that is designed to give us returns of around 15 to 20% per annum. A balanced portfolio would have 50% asset allocation in equity products and the remaining in debt products and gold. The strength of the balanced portfolio lies in the fact that, since we have a high debt allocation our investment corpus would not erode too much. The debt component would give us the balance and the equity component would help us gain the 15% returns on our investment.


1. The debt component gives us a solid foundation to our portfolio.
2. The equity component gives us the higher returns
3. Comparatively less risky than Aggressive portfolio


1. The returns are only half of what an Aggressive portfolio would give us
2. With high levels of inflation in our economy, the returns from the debt market may not beat the inflation

To know how to form a Balanced Portfolio Click Here.

Conservative Portfolio:

A Conservative Portfolio is one that is designed with Capital Protection as the main priority. With debt instruments & gold comprising around 75% we are sure to preserve our capital. Since the equity exposure is also there we can expect marginally higher returns than what a fully debt oriented portfolio would give us. A returns of 10-15% can be expected out of a conservative portfolio.


1. Our investment is safe. It may not rise too much but nor would it fall to give us losses
2. The marginal equity exposure would give us decent returns along with capital protection


1. The returns are even lesser than Balanced portfolio's
2. The returns may not even beat the market

To know how to form a Conservative Portfolio Click Here.

Managing your portfolio:

The first step would be to assess your risk tolerance level and then choose the kind of portfolio that would suit you. This is the easy part. Now comes the hard part "Maintaining the portfolio Balance"

Maintaining Portfolio Balance - is the series of actions you would have to do year after year to maintain your portfolio's balance. Let me explain with an example.

Say Mr. X invests Rs. 10,00,000/- in 2007 in an aggressive portfolio. Hence Rs. 700,000/- would be invested in Equities, Rs. 200,000/- would be invested in debt products and Rs. 100,000/- in gold.

Assuming equities are giving him a returns of 30% and debt a returns of 9% and gold 12% the current worth of his portfolio would be

Equities - 9,10,000
Debt - 2,18,000
Gold - 1,12,000

Net portfolio worth - 12,40,000/-

Hence the returns in the 1st year was 24% from his aggressive portfolio.

Since the equities gave him excellent returns Mr. X retained his equity investment as such and did not balance his portfolio to retain his original asset allocation.

This year in 2008 the equities have lost around 50% or more of their value but debt products have been able to give returns of about 11% and gold has given returns of around 15%. So at the end of 2008 what would be his portfolio worth?

Equities - 4,55,000
Debt - 2,41,980
Gold - 1,28,800

Net portfolio worth - 8,25,780/- which is a 33.5% loss when compared to the corpus at the end of 2007.

What if Mr. X had stuck to his original asset allocation of 70% equities, 20% debt and 5% gold? He would have withdrawn the excess investment from equities and distributed it across debt and gold.

Hence his asset allocation at the beginning of this year would have been

Equities - 8,68,000
Debt - 2,48,000
Gold - 1,24,000

And at the end of this year with the same kind of returns his worth would be:

Equities - 4,34,000
Debt - 2,75,280
Gold - 1,42,600

Net portfolio worth - 8,51,880/- which is a 31% loss when compared to the corpus at the end of 2007

Hence by realigning his portfolio to the original asset allocation Mr. X was able to avoid a loss of nearly 2.5% of his corpus which is Rs. 26,100/-

This is not a small amount of money. This example was just explained to illustrate the importance of maintaining the asset allocation. Once we form a portfolio and an asset allocation, we must stick to it until there is something severe that may warrant us to change it. For example with the ensuing credit crisis, bank stocks are the worst hit. At such a time we may want to reduce the allocation to banking sector. At the same time FMCG and Pharma stocks have been able to withstand the onslaught and even post growth in prices. We can reduce the allocation in banking sector and allocate that to these sectors.

Forming a Portfolio is not a one time activity. We have to constantly monitor the performance of our portfolio and realign it whenever necessary. A passively managed portfolio can never equal the returns of an actively managed portfolio.

Happy Investing...

Tuesday, November 11, 2008

How to choose a Stock for your Portfolio

Something that everybody wants to know these days is "How to choose a Stock". Buying shares is something that requires lot of careful analysis and selection if we want our money to get good returns. Since market instruments come with a RISK attached to them, it is all the more important to choose our stocks carefully because after all it is our hard earned money that we Invest. Investments made out of impulse or out of tips from friends or colleagues may work out in a Bull Market but may seldom workout in Bear Markets. During such testing times one thing all of us need to know is "How to Choose a Good Stock"

This article just elaborates on a few criteria that you need to check while selecting a stock for your portfolio.

Stock selection criteria is one in which an investor uses a systematic form of analysis to determine if a particular stock constitutes a good investment and should be added to his/her portfolio.

The objective of stock selection criteria is to:

1. Maximize the total return on investment (appreciation plus any dividends received)
2. Limit risk (according to an individuals risks tolerance levels)
3. Maintain an appropriate degree of portfolio diversification.

It is a widely known fact that a disciplined stock selection approach is one of the primary factors behind the success of well-known investors like Warren Buffet.

Selection Components

Stock picking can be an extremely difficult and complex process there is no foolproof method for reliably forecasting a stock’s future price movements. However, by carefully examining numerous factors, an investor may get a better sense of future stock prices rather than relying on unsubstantiated speculation such as advice from friends etc. Some of the most common criteria that any investor may have to consider while picking a stock for his portfolio may include:

1. Sector Analysis
2. Fundamental Analysis
3. Management Capability
4. Technical Analysis
5. Financial Analysis
6. Market Capitalization
7. PE Ratio
8. Company's Earnings growth
9. Company's Debt Ratio
10. Institutional Ownership
11. Dividend Yields

Sector Analysis

Sector analysis involves identification and analysis of various industries or economic sectors that are likely to exhibit superior performance when compared to the other sectors in the economy. The health of a Stock's sector is as important or even more important than the Stock's health. In other words even the best stock located in a weak sector will often perform poorly because that sector is out of favor. When the industry is heavy weight (Meaning one that is expected to perform well in the next few quarters) the increase in price of good companies in that sector is usually more than average. For example during the IT industry boom, the growth in price of shares of Infosys, TCS etc were way too high when compared to other great companies. Each industry has differences in terms of its customer base, market share among firms, industry growth, competition etc. Learning how the industry operates provides a deeper understanding of a company's financial health. One method of analyzing a company's growth potential is examining whether the amount of customers in the overall market is expected to grow. In some markets, there is zero or negative growth, a factor demanding careful consideration. Additionally, market analysts recommend that investors should monitor sectors that are nearing the bottom of performance rankings for possible signs of an impending turnaround.

Currently financial experts are heavy weight on Manufacturing Industries, Power sectors. They are very much skeptical about the IT & Banking sector due to the economic crisis now.

Fundamental Analysis

Fundamental analysis considers past records of assets, earnings, sales, products, management, and markets of a company in predicting future trends in these indicators and how they may effect a company’s future success or failure. By analyzing a firm’s prospects, we can determine a stock’s intrinsic value and assess whether a particular stock or group of stocks is undervalued or overvalued at the current market price. If the intrinsic value is more than the current share price, then this stock would appear to be undervalued and a possible candidate for investment. There are a few ways that we can use to identify the value of a stock. They are

1. Price-earnings (P/E) ratio - The PE ratio, also called the multiple, gives investors an idea of how much they are paying for a company’s earning power. The higher the PE, the more investors are paying, and therefore the more earnings growth they are expecting. High PE stocks "those with multiples over 20" are typically young, fast-growing companies.
2. Price-Book (P/B) ratio - P/B is the ratio of a stock’s price to its book value per share. A stock selling at a high PB ratio, such as 3 or higher, may represent a popular growth stock with minimal book value. A stock selling below its book value may attract value-oriented investors who think that the company’s management may undertake steps, such as selling assets or restructuring the company, or acquisitions to unlock hidden value on the company’s balance sheet.
3. Earnings growth which may be reflected in measures like the Prospective Earnings Growth (PEG) ratio. The PEG ratio is a projected one-year annual growth rate, determined by taking the consensus forecast of next year’s earnings, less the current year’s earnings, and dividing the result by the current year’s earnings.

Management Capability

The strength of a company lies in the Strength and capability of its management. A company with a sound management that follows strategies to boost the sales and revenue is definitely a good investment when compared to one where the management is not so sound and innovative.

This involves examining perceptions about management and perceptions by management. It includes various qualitative judgments regarding the competence of current and prospective company management, as well as issues related to insider buying, future strategies to increase operations and market share.

The fundamental goal of any public listed company is to "Enhance Shareholder's Wealth". If a company's management is committed to keeping up their goal then it would definitely make a good pick.

Investing in companies with a management team that is committed to controlling costs is a good strategy. Cost-control is reflected by a profit margin exceeding those of competitors. Superior managers "attack costs as vigorously when profits are at record levels as when they are under pressure." Therefore, be wary of companies that have opulent corporate offices, unusually large corporate staffs and other signs of bloat. Such companies are trying to boast of exuberant facilities for staff. Instead this money could have been used effectively to improve the financial balance sheet of the company. Invest in companies with honest and candid management, and always avoid companies that have a history of using accounting gimmicks to inflate profits or have mislead investors in the past. Such companies are bound to affect your portfolio's earning potential.

Technical Analysis

Technical analysis involves examining how the company is currently perceived by investors as a whole. Technical analysis is a method of evaluating shares by researching the demand and supply for a stock or asset based on recent trading volume, price studies, as well as the buying and selling behavior of investors in the recent past. In Technical analysis, we do not attempt to measure a company's intrinsic value. This analysis is usually done for a short term. Based on the demand and supply for a share, we can predict the future growth in price of a company's stock.

In Technical Analysis, we make use of technical indicators that can help us predict the short term price growth of any stock. Some common technical indicators include Relative Strength Index, Money Flow Index, MACD etc.

Relative Strength Index is an indicator of the strength of a security in relation to its sector or the overall market

Money Flow Index is an indicator that uses the Money flow to calculate the strength of a company.

money flow = typical price * volume traded (On any given Trading Day)

Positive Money Flow days are when the price of the share has increased when compared to the previous days closing price. Negative Money Flow is vice versa.

Money Flow Index = (Positive Money Flow / (Positive Money Flow + Negative Money Flow)) * 100

The MFI is a % value and a value of > 80 means the share is being over bought and a value of < 20 means the share is being over sold.

Technical indicators do not analyze any part of the fundamental business, like earnings, revenue and profit margins. Technical indicators are used extensively by active traders, as they are designed primarily for analyzing short-term price movements.

Technical Analysis also helps long term investors. These indicators can help a long term investor identify good entry and exit points for a stock.

Financial Analysis

In Financial Analysis, we consider the balance sheet of the company or the Profit & Loss statement and compare it with the same of other companies in the same sector. If the values in the statements of the company under consideration is stronger than companies of similar size in the same sector then this company would make a better investment option than the others in the same sector.

Market Capitalization

Market Capitalization is one of the indicators that can help us favor a particular stock. Market Capitalization is nothing but the product of the Total No. of outstanding shares of that company and its share's end of day trade price.

Say For e.g., XYZ limited has 1,00,00,000 (1 Crore) shares in the market and the price of a share in the market today was Rs. 65/- then the market capitalization of XYZ limited is 65 crores.

There are 3 different categories in Stocks.

1. Large Caps - Companies with market capitalization of of a few thousand crores
2. Small Caps - Companies with market capitalization of a few hundred crores
2. Mid Caps - Companies with market capitalization that fall these 2 categories

Usually Large caps are the most favorite stocks because they are the stocks of companies that have built a reputation over years with consistent performance and great profits.

The Market capitalization of any company is also an indicator of how much investors value a company and its future prospects.

Price to Earnings Ratio

The PE ratio is a valuation metric that compares a company’s price-earnings ratio with its projected growth rate. Small, high-growth stocks generally trade at higher PE's compared to the Large-caps. If the PE ratio is around 1, the company is considered fairly valued. A PE ratio that is much higher than 1 indicates an overvalued company, and a PE below 1 indicates an undervalued company. While the PE ratio can effectively provide insight in certain evaluations, it is limited by its overriding focus on earnings growth. Revenue growth, cash flow, dividends, debt, and numerous other factors are also critical in determining value. Additionally, while PE is useful for smaller companies it may be misleading for big-caps, since sustained growth is less important to their total returns. PE is most useful when supplementing a thorough discounted cash flow analysis or relative valuation.

Company's Earnings Growth

In investment terminology, earnings growth refers to the annual rate of growth of earnings, or the amount of profit a company produces during a specific period, usually defined as a quarter (three calendar months) or year. Earnings typically refer to after-tax net income. When the dividend payout ratio is same, the dividend growth rate is equal to the earnings growth rate. Earnings growth rate is a key value that is needed for stock valuation.

Usually companies that can sustain their earning's growth between 15 to 30% year on year are considered good investments.

Companies that exceed a 30 percent earnings growth rate are confronted with two fundamental problems:
1. Sustaining a high growth-rate over the long term is extremely difficult; and
2. Stocks growing that rapidly are usually already being actively bought/sold by investors. Hence exposure to these counters may pose an added risk of going down if the company does not live up to investor expectation.

Debt Ratio

Debt-to-Equity (D/E) ratio is one of the key indicators of a company's strengh. If a companies debt levels are excessive, it often proves extremely difficult for managers to raise sufficient cash to finance continued expansion. Without expansion into new markets, corporate growth eventually slows down. Companies with lower debt often have better prospects for future expansion. Additionally, in the event of an economic slowdown, these firms should be in better shape to weather any storms.

Usually companies with lower Debt ratios are better investments. A 25% debt and 75% equity proportion is something very normal for large corporations. Any company with > 35% debt exposure would make a bad choice for investment because they are the most vulnerable lot in case of any economic slow down.

Institutional Ownership

Institutional investors are organizations that trade large volumes of stocks. Percentage institutional ownership is the percentage of outstanding shares that are owned by mutual funds, pension plans and other institutional investors. Most well-known stocks have at least 40 percent institutional ownership.

More than 70% of the trading that happens on large caps in the stock exchanges are on behalf of these institutional investors. When institutional investment in a company crosses 65% it poses unusual levels of risk associated with it. If those investors decide to sell on a particular day the price of the share may bottom out. Hence preferring stocks with relatively smaller levels of institutional participation is preffered. These companies have a greater return potential than ones with extensive institutional investment.

Though companies with high levels of institutional participation may provide breathtaking returns when they are buying, it may not be able to sustain the returns.

An ideal institutional ownership in terms of % would be somewhere between 5 and 65%

Dividend Yields

Dividend is nothing but a periodic sharing of its profits by a company with its investors. Most successful companies have been good dividend payers in the past.

As a rule of thumb, any company that has consistently been paying good dividends over the past few years make good investments for the long term investor.

Companies with high dividend yield may not provide extraordinary capital appreciation, but they would provide a regular additional income to its investors.

Stock Selection Effectiveness

Stock Selection Effectiveness is something that determines the returns on our portfolio. Our stock selection and asset allocation must be balanced. Over Exposure to any particular stock or segment should not be there. Investing more than 10% of our portfolio's worth in one company's stock is considered a very bad idea.

Our portfolio should be balanced with exposure to all sectors. Some sectors may over perform and some may under perform. But a balanced portfolio would always outperform a portfolio that is heavyweight in one particular sector. The returns on such a portfolio is entirely based on the performance of that particular sector and may not match the returns in a balanced portfolio.

For example, Banking & IT stocks were the most sought after stocks in the past few years in the Indian stock markets. They have been providing excellent capital appreciation over the past 2 to 3 years. But, with the current economic crisis they have been the ones that have taken the worst beating in terms of price. Portfolio's that were over exposed to these 2 sectors would have lost more than 50% of its value. But there are some sectors like FMCG and Pharma that have not lost so much like these 2 sectors. So portfolio's that had a balanced sector allocation with adequate exposure to FMCG and Pharma stocks would not have lost that much. Of course these stocks too lost a lot of value but this was limited to around 20% which is far lower that what the Banking and IT sector stocks lost.

A Well Balanced Portfolio is always the best investment strategy....

Happy Investing.

Sunday, November 9, 2008

US Credit Card Crisis

The Latest sensation in the US economy is the Credit Card Crisis. Wondering what do Credit Cards have to do with a economic crisis? Think again....

All of us use credit cards. It is one of the easiest way of purchasing things even when we dont have enough cash. You swipe your card and then make the payment after a few days or weeks.

Banks in the US as usual went on a rampant selling of Credit cards to everyone. Anyone who is in a job can get a credit card. People were offered hefty credit limits, lower finance charges and attractive gifts for owning their bank credit card. Now wouldn't we be lured by such great offers? Naturally we would be. And that's what happened to the millions of American citizens.

Before getting into the details of what has caused this crisis, lets first understand how a credit card issuing bank makes money.

Assuming you go to a shop and buy something for Rs. 10000/- on 16th September 2008. The shopkeeper would get only Rs. 9800/- from the bank. This Rs. 200/- is the upfront profit the bank makes out of your purchase. This amount may vary from bank to bank. It may range from 1% to 3% of the purchase amount.

Then once the bill is generated on 15th Oct 2008 the bank would send you the statement. And as per the statement, your minimum amount due is Rs. 500/-. Since you are running short of cash you just make a payment of Rs. 500/- before the 5th Nov 2008.

Now the bank would charge you a 3% rate of interest on Rs. 10000/- from the date of purchase which would work out to nearly Rs. 500/- and if you happen to purchase something else for Rs. 5000/- this month they would charge interest on this amount as well. So the next statement on 15th Nov 2008 would have an outstanding of Rs. 15150/-

This interest is compounded at 3% every month which would work out to a whopping 40% per annum. Say if you purchase for Rs. 10000/- and keep repaying only the minimum amount you would have paid Rs. 4000/- in the first year as interest and definitely a major portion of your purchase amount would still be outstanding. Apart from this they would charge us a late payment fee of Rs. 300/- every time you miss paying on due date.

The worst is withdrawing cash from your credit card. You would be charged interest from the day you withdrew cash. Plus you would be charged Rs. 250/- for withdrawing cash. If say today morning you withdrew Rs. 10000/- from your credit card and repay it today evening you would be paying them Rs. 10400/-

Moreover high value credit cards come with annual fees of a few thousand rupees for just possessing cards.

Isn't this a lucrative business? You get 2% of the purchase upfront as profit and then you charge the customers exorbitant interest rates.

What went wrong?

Banks issued cards to everyone, even to sub prime customers. (You are thinking "I guessed that..." Kudos to you. Good job) With the ongoing credit crisis in the states not everyone has enough cash to meet their monthly mortgage commitments. With jobs being cut down by many companies, everyone who has credit card debt is repaying only the minimum amount due or not repaying at all.

In case of mortgage loans, at least the banks can take possession of the property. In case of credit cards what can the bank do? All they can do is file a legal petition against the customer. If the customer declares bankruptcy? The money is LOST...

How big is the damage?

Financial experts expect losses/write downs of approximately $75 billion. Yeah you read it right. Seventy Five Billion US Dollars. That's nearly 11% of the bailout package offered by the US federal reserve.

Whats Next?

Some or all of the below things would happen.

1. Banks would increase their annual fee and interest rates.
2. The Credit Limits may be cut
3. New card applications may not be approved
4. Existing customers with a bad repayment record would be asked to close their accounts and surrender their cards
5. Even very credit worth customers may be asked to prove their credit worthiness

If the current economic crisis worsens and we see further job cuts, the credit card crisis may worsen too...

How are the Banks planning to handle this?

Do not worry as of now. The government is not going to take the Tax payers money and propose another bailout package. As per the current laws Lenders are not supposed to suggest repayment plans to the borrowers for credit card debt. The banks are trying to negotiate with the law makers to allow them to negotiate with delinquent customers and propose a repayment plan that would ensure that the customers are charged only nominal interest rates and even though the repayment period is going to be long they would at least get their money back.

The initial plan may reach a few thousand citizens who may opt for the settlement with the card issuing companies. They would be paying their debt as EMI instead of one bulk payment.

This way both the card issuer and the card holder benefit.

In cases where the card holders are extremely delinquent banks may opt to write off the bad debt.

Is there anything good about this?

Definitely Yes. For both people and banks. Banks have been on a lending spree because of the availability of cheap credit. Now they know that they could get hit in a awful lot of ways. Hence they would restrict lending only to creditworthy customers. Due to lack of easy credit people would spend only what they can afford and this would avoid any such crisis in the future.

Let us hope for the best.

Thursday, November 6, 2008


Insurance is something that we hear all the time. Car Insurance, Bike Insurance, Health Insurance Personal accident Insurance, there are a whole bunch of insurance products available.

What is Insurance?

Insurance is nothing but an agreement between the insurer (The Insurance Company) and the insured (You) to pay an amount as compensation if any unexpected event occurs. This amount may vary from a few hundred to even a few crores. The maximum amount the insured person can claim depends on the amount agreed upon as per the insurance policy.

Why do Insurance companies provide Insurance Policies?

Insurance is provided only for events that have a small chance of happening. The company would never insure you for something that is bound to happen. Say for example you cannot insure your car if you are going to use it for Racing. Because, the chances of your car getting damaged during a race is far higher than when you drive it on ordinary roads.

Let me explain Insurance with an example. Person X contacts an insurer say LIC (Life Insurance Corporation of India) and take an insurance policy worth Rs. 10,00,000/- health insurance with critical illness cover for a period of 10 years. For Taking the policy, LIC asks X to undergo a medical test and once the test clears X will start paying a premium of say Rs. 15,000/- per annum. The moment X pays his first premium, the policy is in force and if he
gets any health complications then he can claim the insurance.

Assuming after 6 months X meets with an accident and needs to undergo a surgery. The Doctors estimate the cost of surgery at Rs. 2,50,000/- Now X would provide sufficient proof to LIC that he met with an accident and along with the doctors bills, he would submit all documents to LIC. Once LIC validates the documents it would release a payment of Rs. 2,50,000/- to X.
Though the policy is worth Rs. 10,00,000/- LIC is liable to pay X only the amount required for the treatment. Even if the amount is as small as Rs. 100/- LIC is liable to pay X the money. However, if the treatment expenses is say Rs. 11,00,000/- then LIC would pay X only Rs. 10,00,000/- The remaining Rs. 1,00,000/- needs to be met out by X out of his pocket.

This is the concept of Insurance. Insurance is nothing but an obligation for the Insurer to compensate for any unexpected events that may happen to the insured person.

Why do we need Insurance?

There may be scenario's where the loss that we would incur due to some event would be extensive and we would not be in a position to incur the losses. Say for e.g., the only earning member in the family meets with an accident and is incapacitated from going to work for 6 months, what would the family do for their survival? These are the cases where Insurance comes in handy. The insured person can claim an amount corresponding to his disability
losses and use the money to sustain his family until he is fit to resume his job.

Who Needs Insurance?

Anyone who has people dependent on them definitely needs Insurance. The dependent could be your wife & children, or your parents or your minor siblings etc. The purpose of having insurance is to ensure that our dependents are able to lead a decent living even if anything unfortunate
happens to us.

How much Insurance do we need?

If you have atleast one dependent you need to be insured for atleast 5 times your annual income. If your annual salary is Rs. 5 lacs then you need to be insured for atleast 25 lacs. The more the dependents the more the insurance. Take the case of a person who is married and has two children who are in school. He would need atleast 10 times his annual income as insurance
because, in case of any unfortunate event occuring to him, his wife and children would be stranded. The family would need financial support to ensure that they are able to lead a peaceful life. If you have any loans outstanding, your insurance cover has to increase by the same amount.

Lets say Mr. X is married and has a Son who is 10 years old. He is the only earning member of the family. He has a home loan worth Rs. 15 lacs with ABC Bank. His annual income is Rs. 5 lacs per annum.

Mr. X would need an insurance of atleast 65 lacs ((10 * 5) + 15) Ten times his annual salary plus the amount of home loan.

Lets take three scenarios...

1. Mr. X has no insurance at all.

The Bank would want to take possession of the house to recover its loan amount. Hence Mr. X's family would have to move out. Since X is the only earning member of the family, his wife and son have no source of income. They would be stranded and would have to depend on their relatives for their sustenance.

2. Mr. X has insurance but is only worth Rs. 50 lacs (He was smart enough to
get himself insured for 10 times his annual income)

The Bank would want X's family to repay the home loan outstanding amount. Lucky that X is insured for 50 lacs. His wife would pay out 15 lacs from the insurance amount and continue to stay in their house but, the corpus that she has to sustain herself is badly diminished because of the loan amount payment. But definitely this situation is far far better than the previous

3. Mr. X is insured for Rs. 65 lacs or more.

The Bank would want X's family to repay the home loan outstanding amount. Since X is insured adequately, his wife would be able to pay out Rs. 15 lacs comfortably and also would continue to have Rs. 50 lacs or more in her savings using which she can continue to lead a decent living. She can use this money to educate her son and make sure his future is secure.

Now I guess you know the importance of Insurance :)

Types Of Insurance:

1. Health Insurance
2. Disability Insurance
3. Life Insurance
4. Automobile Insurance
5. Theft Insurance
6. Travel Insurance
7. Property Insurance etc

Confusing Investment and Insurance:

A lot of us confuse Investment and Insurance. Investment is something that we save up to use while we are alive. Insurance is something we save up for our family to use once we are gone. The goals of Investment and Insurance are totally different. A lot of us take Insurance policies as investments. This is the reason why there are a whole group of people running behind us
telling us how great their new Insurance policies are.

Let me explain with a simple arithmetic. Assuming you pay an Insurance policy premium of Rs. 25,000/- for a policy that would mature in 20 years The Insurance agent would have told you that the policy is worth Rs. 5 lacs and you would get a bonus amount equivalent to it and hence you would be getting Rs. 10 lacs at the end of 20 years. This is a big amount and obviously most of us would be lured into taking this policy. What do we forget here?

1. A fat portion of the premium we pay in the first few years would be paid to the agent as a commission
2. Every year a portion of your premium (Atleast 2%) would be paid to the agent as a commission
3. The Insurance company would deduct a portion of our premium (Atleast 5%) as mortality charges.
4. The Insurance company can invest only in debt instruments and hence the returns on our investments cannot exceed 8 or 9 % per annum.

Assuming you invest the same Rs. 25,000/- every year in a bank Fixed deposit that earns an interest of 9% per annum, what do you think will be the maturity amount? You wont believe me. It is Rs. 13,62,745/- which is Rs. 3,62,745/- more than what your insurance policy would give you. (Assuming what your agent said was true and you would get Rs. 10 lacs)

You will be wondering how this amount of more than Rs. 3 lacs got reduced. The answer is simple: "COMMISSION". Your Agent eats this amount from your investment and hence you are getting only 10 lacs.

Am I against taking Insurance Policies?

No, Definitely not. The purpose of Insurance is to help our family once we are gone. Hence we should opt for policies that pay our families money if anything unfortunate happens to us. Such policies are called "Pure Term Life Insurance Policies". You pay a fixed premium every year for the next 25 or 30 years and in any unfortunate event the insurance company would pay your
family the insured amount. If you outlive your policy then you would not get any money.

For the same 5 lac insurance policy that we considered above, you need to pay only around Rs. 5000/- every year. Even if you invested the remaining Rs. 20,000/- in bank FD's for the same period of 20 years you would have accumulated Rs. 10,90,196/- which is 90 thousand more than what that policy gave you. Plus you had the same insurance cover for the same duration.

Why do Agents not recommend such Policies to us?

The Answer is simple: "COMMISSION". Such policies have the least commission percentage and hence agents seldom advise us to take such kind of policies. Though these are the cheapest kind of policies with the most benefits for our family, the agents do not advise us because they do not get anything out of such policies.


Always think before you take an insurance policy. Think if you really need this policy. Think if this is the best policy that suits your need. Do not take Insurance policies for Investment.

Happy Insuring.....

Wednesday, November 5, 2008

Credit default swap

A credit default swap (CDS) is a credit derivative contract between two counter parties, whereby the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit event in respect of a third party or reference entity.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy). Credit Default Swaps can be bought by any investor; it is not necessary for the buyer to own the underlying credit instrument.

A CDS is like a Health insurance policy that we may take to cover up for the cash requirements if we get any health problems. We pay a premium to the insurance company and if we get any health problems, the insurer would pay for the medical treatment.

Let us take into example what happened in the US Markets:

The Investment bank that bought the subprime loans contacted Insurers like AIG and created swap agreements with them. They would be making periodic payments to AIG over the span of the loan tenure and if anything unexpected happens and the loan is defaulted the Insurance company would pay the amount to the Investment bank.

Here the Investment Bank does not own the Loan but still it has entered into CDS agreements with the insurance company to save itself in the event of loan default.

The Price or Spread of the CDS is the amount that the investment bank would pay to the insurance company in return for the protection. Say if the spread is 0.5% or 50 basis points (one basis point = 0.01%) for a protection worth Rs. 10,00,000/- then the investment bank would pay the insurance company a premium of Rs. 5000/- every year. This payment needs to be made until the CDS agreement is in force or the loan becomes defaulted.

If the Spread of a CDS is higher, then it effectively means that the probability of default of the CDS agreement is more than normal since they are being charged a higher premium amount.

The Market for CDS Instruments:

Credit Default Swaps are by far the most actively traded Credit Derivatives product. There is no centralized exchange or clearing house for CDS transactions; they are all done over the counter (OTC). This has led to recent calls for the market to open up in terms of transparency and regulation

You may be wondering why would insurance companies enter into CDS agreements. The reason is Simple. Default is considered as a rare occurrence. Insurance companies expect only 0.2% of all CDS contracts to default every year. So most of the payment is only one way.Their assumption is what spelt their DOOM...

The Downfall:

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation, and that because all contracts are privately negotiated, that the market has no transparency. Furthermore there have even been claims that CDS's exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.

When the Housing bubble burst, people started defaulting on Loans. The Banks were unable to make the payments to the investment banks who converted their Loans into MBS. The Investment banks in turn went to the insurance companies to cash in their CDS contracts to save their losses. When the claims exceed the total premium collected, no insurance company would be able to survive. This led to the downfall of insurance giants like AIG and the government had to intervene and save it.

Sunday, November 2, 2008

Will the $700 billion bailout package Workout?

After the US Senate passed the $700 billion bail out package, we still haven't seen any significant upside on the US Stock markets. People are wondering, "Isn't the huge pile of money allotted by the Treasury secretary Henry Paulson supposed to solve the crisis?"

Well its not as simple as we think...

Economists worldwide feel that the bail out pill may only dull the pain, but may not provide the much needed cure. Whats worse? Some people even feel that it could leave a deeper hole in the economic crisis. The Fed is taking steps to infuse liquidity into the markets which they feel would improve the cash flow in the market and stabilize the economy. But banks now have turned
super cautious. They were reckless in the past few years when it came to granting loans. The damage that has caused to these banks has made them too conservative. Even with the availability of easy cash from the Fed, banks may not opt to give off too many loans.

The Treasury's gesture of buying out the toxic Mortgage Backed Securities assets stuck with the
banks may help temporarily improve the banks balance sheets, but that doesn't guarantee the fact that banks would go ahead and give off loans. The bail out may not ease the cash flow in the market the way it plans to do so.

The current economic situation is one of volatility. Nobody is sure as to what would happen. There have consecutive months of job losses, bankruptcy, sales slowdown in automobile industry etc. Banks appear to be increasingly unstable. People have lost faith in Insurance companies. Financial companies are stuck with dubious debt products.

The Premium asked by insurance companies against Credit Default Swaps have gone sky high. Recently a major US Bank, took a credit default product with a credit spread of approximately 1000 basis points. Which is 10% of the default coverage amount. This means that if the bank to take a default insurance worth $ 10 million, it would have to pay $1 million every year,
which is more than 10 times of what companies pay. Insurance companies are not sure of the quality of the loan product against which banks are asking for credit default products and hence they are not ready to risk too much money. The Insurance companies can neither deny such products nor can they deny default claims. Hence to save themselves they have increased the credit spread.

People do not feel that the bailout package would be a complete failure. Mr. Paulson has inbuilt a lot of flexibility in the act in his attempt of injecting liquidity into the market. But first the treasury has to find out what assets to buy and at what price to buy. Nobody is sure of the quality of the assets that the treasury is going to buy. The Treasury is not going
to buy the assets blindly. This is a kind of investment which is an attempt to infuse liquidity into the markets. The Treasury is eligible for the payments that the MBS units are supposed to get from the banks. The Treasury would opt to sell these units at a future date at a profit. No one is sure whether this extreme risk the Treasury is taking with the Tax payer's money
would work out.

The process of identifying the assets and distributing the fund across the list of distressed financial institutions may take at least a month or so to complete.

A Leading financial expert feels that this $700 billion proposed by Mr. Paulson may not be sufficient to save the country's economy. Even if the 700 billion dollars is spent efficiently in buying up illiquid MBS assets, it may not be sufficient to cover up the void that has been created. the Treasury may go back to the government asking for more dollars. The reason
they would say is simple, "These funds were not sufficient to infuse liquidity". Once Investor & Bank confidence is destroyed, it is not easily restored. It would take months and even years for things to settle down.

But, in spite of all this, if this bailout plan works out the way it is expected to do so, we can expect a dramatic turn of events which could restore investor confidence and bank confidence and could boost the economy to what it was before. Though this may not happen overnight but it could
accomplish its intended effects in a few months.

Let us hope for the best :)

Saturday, November 1, 2008

Emergency Economic Stabilization act of 2008 - The US Bailout Package

The Emergency Economic Stabilization Act of 2008 commonly referred to as a bailout of the U.S. financial system, is a law authorizing the United States Secretary of the Treasury to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, from the nation's banks. The Act was proposed by U.S. President George W. Bush and Treasury Secretary Henry Paulson during the global financial crisis of September-October 2008.

The purpose of the plan was to purchase bad assets, reduce uncertainty regarding the worth of the remaining assets, and restore confidence in the credit markets.

When the Bill was initially introduced, it had been rejected by the US Senate on Sep 29th 2008. It was then amended and approved by the US Senate on Oct 3rd 2008. President Bush signed the bill into law within hours of its enactment, creating a $700 billion Troubled Assets Relief Program to purchase failing bank assets..

Proponents of the bailout plan argued that the market intervention called for by the plan was vital to prevent further erosion of confidence in the U.S. credit markets and that failure to act could lead to an economic depression.

Opponents objected to the massive cost of the sudden plan, pointing to polls that showed little support among the public for bailing out Wall Street investment banks, and claimed that better alternatives were not considered and that the Senate only tried to force the passage of the unpopular but sweetened version of the bailout through the opposing House and was successful in this attempt. Opponents of the rescue plan argue that since the problems of the American economy were created by excess credit and debt, a massive infusion of credit and debt into the economy only excaberates the problems with the economy. The bailout infuses credit and debt into the economy because the government is creating the money out of thin air and thus immediately creating more credit and debt.

What Happened Before this Bailout package was announced?

The US Subprime financial crisis, caused a massive void in the country's economy and the liquidity in the markets was affected badly. The US Treasury Secretary Henry Paulson, proposed that the US Treasurey acquire $ 700billion worth of Mortgage Backed Securities. The proposal called for the federal government to buy up to US$700 billion of illiquid mortgage-backed securities with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities.

Mortgage asset purchases

A key part of the proposal is the federal government's plan to buy up to US$700 billion of illiquid mortgage backed securities (MBS) with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. The draft proposal of the plan was received favorably by investors in the stock market.

This plan can be described as a risky investment, as opposed to an expense. The MBS within the scope of the purchase program have rights to the cash flows from the underlying mortgages. As such, the initial outflow of government funds to purchase the MBS would be offset by ongoing cash inflows represented by the monthly mortgage payments. Further, the government eventually may be able to sell the assets, though whether at a gain or loss will be known only in future.

The Reasons for the Bailout Package:

1. To Stabilize the economy
2. Improve Liquidity
3. Improve Investor Confidence
4. Reduce the impact of the financial crisis on the US Economy and GDP.

Is there a Conflict of interest?

There is concern that the current plan creates a conflict of interest for Paulson. Paulson is a former CEO of Goldman Sachs and Goldman stands to benefit greatly from the bailout. Paulson has hired Goldman executives as advisors and Paulson’s former advisors have joined banks that will also benefit from the bailout. Furthermore, the original proposal exempted Paulson from judicial oversight. Thus there is concern that former illegal activity by a financial institution or its executives might be hidden.

The treasury staff member responsible for administering the bailout funds is Neel Kashkari, a former vice-president at Goldman Sachs.

Because of the above mentioned reasons, a lot of financial experts in the US are not too appreciative of the Bailout package. The public too is not too happy because, they do not want the Tax Payer's money to help out the financial guru's who screwed up the economy because of their greed.

Troubled Assets Relief Program

The program is run by the Treasury's new Office of Financial Stability. This is the name of the program that will be taking care of infusing the much needed stability & liquidity into the markets. The fund will be split into the following administrative units:

1) Mortgage-backed securities purchase program: This team is identifying which troubled assets to purchase, from whom to buy them and which purchase mechanism will best meet the bailout policy objectives.

2) Whole loan purchase program: Regional banks are particularly clogged with whole residential mortgage loans. This team is working with bank regulators to identify which types of loans to purchase first, how to value them, and which purchase mechanism will best meet the bailout policy objectives.

3) Insurance program: We are establishing a program to insure troubled assets. They have several innovative ideas on how to structure this program, including how to insure mortgage-backed securities as well as whole loans.

4) Equity purchase program: They are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

5) Home ownership preservation: When the treasury purchases mortgages and mortgage-backed securities, they will look for every opportunity possible to help homeowners.

6) Executive compensation: The law sets out important requirements regarding executive compensation for firms that participate in the TARP. This team is working hard to define the requirements for financial institutions to participate in three possible scenarios: One, an auction purchase of troubled assets; two, a broad equity or direct purchase program; and three, a case of an intervention to prevent the impending failure of a systemically significant institution.

7) Compliance: The law establishes important oversight and compliance structures, including establishing an Oversight Board, on-site participation of the General Accounting Office and the creation of a Special Inspector General, with thorough reporting requirements. We welcome this oversight and have a team focused on making sure we get it right.

TARP participation restrictions

Companies that sell their bad assets to the government must provide warrants so that taxpayers will benefit from future growth of the companies. The President is to submit a law to cover taxpayer losses on the fund, using "a small, broad-based fee on all financial institutions." In order to participate in the bailout program, "companies will lose certain tax benefits and, in some cases, must limit executive pay. The fund has an Oversight Board so that the U.S. Treasury cannot act in an arbitrary manner. There is also an inspector general to protect against waste, fraud and abuse.

Friday, October 31, 2008

Write Down

A Write down in banking terminology means, deducting a portion of the banks assets from its net worth because they have become non collectible.

For e.g., when a bank grants a loan to a person A for Rs. 10 lacs and he declares bankruptcy after paying the first 3 EMI's then the remaining principal amount of the loan would become non collectible. Hence it would have to be written down from the banks assets.

Write Downs in the current US Financial Crisis:

With the ongoing economic crisis in the US, a lot of companies have had to write down a lot of illiquid MBS and Sub Prime Loans.

A MBS refers to Mortgage Backed Securities. To know more about MBS click here.

A Sub Prime loan is a loan granted to a non creditworth customer. The customer may not have enough income to even pay back the EMI. To know more about Sub prime loans click here.

Some Major write downs in the US:

1. Citigroup = $39 billion (Approximately INR 2 lac Crores)
2. Merryl Lynch = $29 billion (Approximately INR 1.5 lac Crores)
3. Morgan Stanley = $ 11.5 billion (Approximately INR 57000 Crores)

Some Major write downs in UK:

1. HSBC = $20 billion (Approximately INR 1 lac Crores)
2. Barclays Capital = $3.1 billion (Approximately INR 15000 Crores)

Write downs in India:

1. ICICI Bank = $0.264 billion (Approximately INR 1200 Crores)

$ - US Dollar
INR - Indian Rupee

Monday, October 27, 2008

Saving Income Tax through Investments

Every Indian who earns an income in India is entitled to pay tax on his income. As per the Indian tax laws we the tax payer is allowed to save his income tax by using the provisions under Sec 80C of the tax laws. To know more about the Indian Income tax laws and the options using which we can reduce our tax pls refer to this link. Income Tax

In this article we will be checking out some investment options that would help us save some cash for our future.

Why do we need to invest?

This is one big question that most of us have but we do not know the best answer. The most common answer is "To Save Income Tax".

Yeah that too is an answer but that is not the first of the reasons. There are a few other compelling reasons why we should invest.

1. Inflation - The Inflation rate of our country is currently at 11%. This means that anything you buy this year for Rs. 100 would be worth Rs. 111 next year. Next year our income would rise but so would our commitments. So if our money is not growing at least at the rate at which the inflation is going, then effectively the worth of our money is going down.
2. Future Income - Today we are in a good job and earning a decent income. After 20 or 30 years we would have to retire some time. After that we would not want to compromise on the life style we are used to. Nor would we want to be dependent on our children to support us. So what is the only option? We must save up some cash that we can use after our retirement. This is possible only by investment.
3. Financial Security - Financial security is something all of us would want to have. If anyone asks us what would make us feel financially secure what would we say? A bank balance of 10 lacs? Yeah that sounds nice. But how would we get such lump sum amounts? The answer is simple. If we start investing now, once our income earning days are over we would be able to sit on a pool of cash that would make us feel financially secure...
4. Saving Income Tax

I have intentionally placed Saving Income tax as the last option because, we must not invest just for the sake of saving tax. We must invest sincerely because we are the ones who is going to enjoy the fruits in future.

In my article on Income tax i have mentioned about 9 options that are available for us under Sec 80C to save tax. Out of these I am going to consider the investment options available. We would not be considering Life Insurance and Home loans because they are not investments but a protection and an asset for us. We will be looking at them one after the other in the increasing order of risk and also the increasing order of Returns.

Remember - "The Greater the Risk, Greater are the Returns" This doesn't mean that we must only in high risk instruments. Definitely not. We must have exposure to safe avenues of investment too because after all it is our hard earned money and we do not want it to go waste. We must maintain a good balance between risky investments and safe investments so that our principal is intact and at the same time our money must grow and beat at least the Inflation rate.

1. Provident Fund

All of us know what Provident Fund is. This is a portion of our salary that our employer deducts every month. This money is remitted to the government of India's PF trust. This money is used by our government for its cash needs. Once we retire or close our PF account, the money that has accumulated against our name would be given back to us. The money in our PF account grows at the rate of 8.5% per annum compounded every year.

Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PF is only 8.5%

Investment Strong points:
a. Extremely Safe
b. A small amount every month can help us make up a good corpus over the long run.

a. Only average returns.

Note: Ever wondered why the government of India has made PF mandatory for all employers? Even the government wants us to save some money for our future. The best way is to make it mandatory at the source which gives us the income. We should be thankful to our government for doing at least some good things for us :-)

2. Public Provident Fund

PPF is similar to PF with the only difference being, anyone can open a PPF account by visiting the nearest State Bank of India branch. PPF is also managed by the government of India. Once we open a PPF account we can deposit cash in our PPF account anytime. There is one restriction here. We must deposit at least Rs. 500/- every year to keep our PPF account active. The maximum amount we can remit in our PPF account every year is Rs. 70,000/- Our PPF account remains active for 15 years and if we want we can extend it by a further 5 years. We cannot encash the entire amount in our account before the tenure of 15 years. Of course we can do partial withdrawals from our account but we cannot take out the entire corpus.

Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PPF is only 8%

Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.

a. Only average returns.
b. Very long lock in period. We cannot take out our cash before 15 years
c. We need to deposit at least Rs. 500/- every year to keep the account active.

3. National Savings Certificate

NSC certificates are certificates of deposits issued by the government of India. Any Indian can deposit cash in NSC. This money would be used by the government for its cash needs. NSC gives us a return of 8% per annum compounded every half year and we can get our amount inclusive of the interest at the end of 6 years. 6 years is the lock in period on NSC certificates. Since these certificates are issued by our government they are extremely safe.

Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on NSC is only 8%

Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.

a. Only average returns.
b. Long lock in period. We cannot take out our cash before 6 years
c. The Interest earned on NSC is taxable

4. Bank 5 year Fixed Deposits

The latest addition to the tax saving investment options is the Bank 5 year fixed deposit. We can deposit our cash in this special scheme of fixed deposits in any bank. Most banks give us returns as high as 10% for these deposits. The money we deposit is locked in with the bank for 5 years after which we can take back our money. We can opt for periodic interest payments or we can get the interest along with the principal at the end of 5 years.

Safety = High because backed by the RBI
Returns on Investment = Average - Our Inflation is 11% and the returns on FD's is only 9% or 10% max

Investment Strong points:
a. Very Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.

a. Only average returns.
b. Long lock in period. We cannot take out our cash before 5 years
c. The Interest earned on Bank FD's is taxable if it is more than Rs. 10,000/- per annum.

5. Equity Linked Savings Scheme (ELSS)

ELSS mutual funds are a category of Mutual funds that are exempt from Income tax. To know more about Mutual funds Click Here

ELSS mutual funds are special funds that invest predominantly in Large cap stocks (Companies that are very large with exceedingly high capability of profit making, that have been successful for a number of years) ELSS funds have a lock in period of 3 years after which we can take our money if we want. Since the money we invest is invested in the Share market, the returns are not constant. In years in which our market performs well we can expect exceptional returns but at the same time it carries a risk. If our markets perform poorly we may incur losses. But over the years, the Indian share market has been able to give a returns of at least 15-20% year on year.

Safety = Low, because the money is linked to the share market.
Returns on Investment = Very high - If the share market goes up, our returns may exceed 20%. In the past 2 years until Jan 2008, our markets have dished out returns as high as 50%

Invest Strong Points:
a. High returns
b. A small amount investment every month can help us accumulate wealth over the years.
c. Short lock in period. ELSS is the only investment option that has a lock in period of only 3 years.
d. Returns on ELSS are tax free. Both Dividends and the maturity amount.

a. High risk because it is linked to the stock market

The most important point:

This is the most important point of this article. "Starting Early"

Starting Early means, starting investing at a young age. Assuming two friends A & B start investing. A is 25 years old and invests Rs. 50,000/- every year for the next 20 years. B is 35 years old and invests Rs. 1 lac every year for the next 20 years. Who do you think will have more cash by the time they are 60 years old?

If you said B then you are wrong. A would have more money because he started early. His investments were able to earn an income on themselves for 35 years which was 10 years more than B's investments.

Assuming you can invest Rs. 1 lac every year for the next 25 years in an instrument that gives you a returns of 10% per annum. By delaying your investment by one year your corpus would fall short by Rs. 3.5 lacs at the end of 25 years. That is the power of compounding. The interest you earn this year would earn interest for you next year. So Start Early :)

Happy Investing...
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