Saturday, October 11, 2014

Does My Portfolio Need Equity Investments?

This is a question that every investor has in his/her mind. Many of us stay away from the equity markets because of fear that we might lose money or just because we don’t have the time or the know-how to do so. So, invariably most of us end up investing only in “Safe” investments like PPF or Fixed Deposits. A couple of months back, I even penned down a book titled “Safe Investment Havens of India” which covers all the good safe investment options. Though safe investments offer us the 100% guarantee on our principal and give us decent returns, the burning question is – is it enough?

The purpose of this article is to help you get an Answer to this question..

The Answer:
               For a change, I want to give you an answer to this question right away. Yes, your portfolio needs Equity Investments. You will learn the reason why in the next few paragraphs…

Important Note: Not everyone can afford to have the same % allocation toward equities. Youngsters can afford to have a much higher allocation toward equities than their parents who are on the verge of retirement. I had explained a concept called “Lifestage based Investments” and “Optimal Portfolio Allocation” that outlines how much exposure one should have toward equities based on their age in my book titled “Your Complete Guide to IndianIncome Tax & Retiring as a Crorepati”. You can read a free preview of the book here: “Free Preview

Reason 1: Tax Implications

Income from debt instruments such as fixed deposits has to be added to your taxable income and is taxed as per your tax bracket. If you fall in the 30% bracket, the return earned on your fixed deposit gets lowered by that much.
So, lets say you are in the 30% tax slab, 30% of the interest you earn is effectively paid as income tax. So, a 10% return earning FD is actually giving you only 7% after tax.

Reason 2: Inflation

Before you invest in any instrument it is necessary to consider the 'real returns' generated by the Investment. 'Real returns' is nothing but the rate of returns over and above the inflation.

For example, if your investments generate 6% returns (after taxes) and the rate of inflation is 5%, your real returns would be 1%.

So, in a country like India where Inflation is around the 7% or 8% range most of the time, your fixed deposit (or any other safe investment) usually would generate only 1% or even lower real returns…

Why Inflation is Very Important!!!

You may be wondering why Inflation Rate is so important. If the annual inflation rate is about 6%, anything that costs 100 rupees this year will be costing 106 rupees next year. So, if your investment is not worth at least 106 rupees or more at the end of the year, your investment is effectively eroding in value. It won’t be sufficient to buy the same item that you could’ve purchased this year.
Get the picture?

Some Last Words:

This article is actually outlining the negatives of safe investments. So, does this mean – I should stay away from Safe Investments?

No, definitely Not. The purpose of this article is not to scare you away from safe investments. Safe Investments like Fixed Deposits or PPF should be a part of every investors portfolio. The purpose of this article is to highlight the fact that, by just focusing on safe investments, our returns/profits may not even beat the inflation rate. By including an appropriate % of Equities in your investment, your total portfolio can actually grow at an overall rate that is higher than inflation.

Lastly, you may be wondering, are equity investments tax free? Actually – YES. If you stay invested for at least 1 year or more and transact through a registered stock exchange after paying the Securities Transaction Tax (STT) the profits from equities is fully tax free. Only those profits you earned from shares you sell within 1 year will need to be considered for tax calculations. Same is the case for Equity Mutual Funds.

Happy Investing!!!

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