Bank Account: Are we using bank account effectively? – Part-1

Continuing on the comments which I received for the calculations I covered on my previous post IPO-Should you invest in IPO, I really feel happy that the readers have now started to look at the fine prints of the calculations. Many of you have asked the question that saving bank accounts hardly pay 3.5% to 4% interest while I’ve taken 5.5% in my calculations. Then, the second question was that IPO process and refund takes only 3 weeks and not 2 months. These are valid questions and I feel happy that we are now getting into looking at the nitty-gritty details of finance.
However, still I feel that people are not reading and grasping effectively. Let me explain the fine details further.

In my previous post, I’ve mentioned the following:
The entire process starting from IPO subscription application to getting the refund takes around 2 months. Even if it takes 1 month, the mechanism by the banks to calculate interest ensures that you loose the interest for 2 months.

Then, I’ve also mentioned the mechanism banks use to calculate interest:
For people who don’t know, the banks pay interest only on the MINIMUM amount of money in your bank account, between the 10th and last day of the month. For e.g., if I have 2 Rs. in my bank account of 10 July, and I deposit another 1 Lakh on 11 July, I will get interest only on 2 Rs. because the minimum amount that I had between 10th and last day was only 2 Rs.

One of the readers has left the comment that it takes only a maximum of 3 weeks time to get the refund. It may be true, but my experience is that it takes a minimum of 1 month. Let’s look at an example: Suppose there is an IPO that opens on 15th July. You apply for the IPO on 15th July by taking the money out of your bank account. Even if it takes 3 weeks, it will be 6th August till you get your cheque; maybe later because of postal delays. Deposit it for clearing, it will be another 3 days to clear the cheque. Then, if there is a weekend in between, the money gets credited to your account only on Monday. This ensures that the money comes to your account only on 11th August or later. So ultimately, you will have to loose the interest for 2 months – July as well as August. Remember, we are talking about the fastest IPO process of just 3 weeks. In practical sense, no IPO gives refund before a month. Even the ECS system takes a month for refund. So ultimately, you loose the interest on your money for 2 months.

Second point: regarding the 5.5% interest rate. How much do you play around with your money? When you invest for an IPO, do you apply with all the money you have and don’t keep anything in your bank account? I’m sure, your answer would be NO.

This brings us to a fundamental question: Are we using our bank accounts effectively? Are we keeping enough money for emergency requirements in our bank accounts?

Personally, what I do is as follows: I keep a minimum of 25,000 Rs. in my savings bank account at any given point of time, like an emergency fund. May be I will need the money for an emergency reason, like hospitalization of a family member, or similar such unfortunate situations. I know smart-alecs will suggest having a credit card with 1 Lakh limit, but not all hospitals and emergency situations can be tackled by swiping a credit card. Moreover, establishments may charge 2-3% extra on credit card usage, which is not very good. If the establishment does not charge anything for credit card, then I will happily swipe my card. But there is definitely a necessity to keep an emergency fund in your savings account.

Any money above this 25,000, I ensure that it gets converted to a Fixed Deposit. The advantages of Fixed Deposits compared to a savings account are as follows:
• You don’t have to worry about the minimum amount between 10th and last date of the month. An FD gives you fixed interest for a fixed period, irrespective of the date it was issued.
• FD earns higher interest as compared to a savings bank account. The 5.5% rate that I mentioned was for FD.

Continue to Part II of this article:

Bank Account: Are we using bank account effectively? – Part-2

This is part 2 of the article Bank Account: Are we using bank account effectively? . In case you've not read the first part, please read it before preceeding with this one.

Every individual keeps (and must keep) an emergency fund in his savings bank account (like 25K I have). If you don’t keep an emergency fund, then you are making a very big mistake.
Many of the readers claim that they play around in the stock market with the money that they don’t need. Obviously, that will imply that you are investing in IPO the money that is over and above the emergency fund money. For e.g., if I have 75K in my bank account, I will invest maximum 50K for IPO and leave my 25K as emergency money. And if you have this extra money lying in your bank account, it will be foolish if you do not convert it to FD, given the higher amount of interest it will earn, as compared to a savings account.

Numerous types of accounts are available with the banks –especially private banks. We don’t take the opportunity to explore them.

I saw this punch-line in one of the commercial advertisements: “The better a thing works, the more we tend to take it for granted”. For the finance world, it can be modified as follows: “The simpler and risk-free a product is, the more we tend to take it for granted”.
That’s how we treat our bank accounts – we ignore them completely.
Similar thing goes for the IPOs. The so called good company IPOs appear to be risk free – which may be true, but what we forget is that there is a cost attached to application of IPO, as explained in my previous post.

For e.g., I have an account with a private bank. It comes with a so called “Easy Fixed Deposit”. Which means: I declare that I will maintain a minimum 25 K as my balance in the account. If the balance is more than 25K, anything above 25 K will automatically get converted to an FD in multiples of 5K. So If I have 28K in my bank account on 30th July and I get my salary on 31st July as 30K, taking the total to 58K, then this extra money above 25K, which is 58-25 = 33K, rounded to multiple of 5K, meaning 30 K will automatically get converted to FD and earn higher rate of interest. My total bank balance will still show 58K, but divided across 2 accounts: 28K in savings and 30K in FD.
Now suppose I need to withdraw 55K on 30th August. So my FD will be broken automatically, and I will receive interest for 1 month, which will be 5%, instead of 3.5% offered on savings account. Another benefit is that though the FD is breaking 1 day before the last day of the month (31st Aug), I will still receive the high FD interest for every single day. In case of savings account, I would have lost the interest on my withdrawal amount of 55k. The major benefit comes with the power of compounding, incase of FDs.

Now don’t jump on and start looking for opening an account with the private bank that offers this facility – a new bank account will come at a cost. First enquire with your bank if it has this scheme – I’m sure they should. If they don’t, then go for the manual way. Every reader of this blog has access to internet. I’m sure each of you will have internet banking as well. Almost all banks now offer FD request through internet banking. Try that, and make sure you utilize the money in your bank account effectively. Sometimes, simpler things work better than we assume :- )

Another thing that I want to clarify is that I’m not against IPOs. IPOs are good, and you can really make money out of it. The only thing that I want to highlight in my past article was that there is a major factor called LUCK and probability that determines whether you will be allotted shares or not. Do a self assessment, if you have applied for numerous IPOs in the past, were you allotted shares of all of them? Take the complete calculation for each of the IPO that you applied for, and you will see that the profit you made in one IPO was marginally better than the cost that you paid by loosing the interest on an unsuccessful IPO application.

I also mentioned that IPO applications should be made for long term that too for the businesses that you believe will be good. It’s completely subjective and left to the investor. Let me repeat once again: My articles are for telling everything about a product and the cost attached to it – You have to decide whether to take a chance or not :- )

Keep visiting this blog for further content.
Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

IPO-Initial Public Offer – Should you invest in IPOs? Part-1

There has been a recent buzz in the air about the IPOs – infact, majority of the individuals start in the stock market by investing in an IPO and then later enter the secondary market trading. In this article, I aim to show some calculations and explain whether an investment in IPO subscription is really worth or can you look for better options.

Basically, the company, as long as it is privately owned, remains un-capitalized – meaning, it has a value, but it cannot get the benefit of that value. For e.g. you buy a house for 15 Lakh Rs and stay in it. After 5 years, the price of the house tripled, and reached 45 lakhs. You feel happy that your house is now worth triple the value. But can you capitalize on it OR can you benefit from the price rise? The answer is NO. You cannot sell the house because you are staying in it. So though you are having a good valuable house, you can’t unlock the value. The only thing you can do is feel happy about the value of the house or proudly tell your friends that now your house is triple in value. But unfortunately, there is no way to capitalize on this value increase, as long as you’re living in the house.

Similar thing goes for the companies – as long as they are owned by individuals or private partners, they cannot capitalize upon its value. So the best way is to sell a certain percentage of business to the public and get the money. The easiest way to do it is through an IPO.
For e.g. Wipro may decide to come up with an IPO. The chairman, Azim Premji, divide the company in 100 Million equal parts called shares. He decides to keep 85% of the shares with him and sell the remaining to the public through an IPO for a price, say 100 Rs. each share. So through IPO, he will sell 15 million shares at a price of Rs. 100 each and will be able to collect 1500 million Rs. So what he is doing is keeping the majority of the shares with him, so that he has full control of the company, and selling a small portion to the public for capitalizing the value of his business and get some money for further expansion or for entering in a new business segment. The portion of shares kept by Azim Premji ensures that he has full control over the company, and also makes him one of the richest men in the country. Please note that the nos. presented here are only for example, they are not the exact figures of Wipro.

The question is: Why would some good running business be interested in sharing his business profits with the public, if it is running smoothly and doing well.

Why does a company brings an IPO? When a company comes with an IPO and investors subscribe to it by applying for shares, they become partners in the business of that company. Why will a profitable business come out with an IPO and share the profits with millions of investors? The one and only reason for any company to come up with an IPO is that it needs money. Apart from that, there are no reasons for any business to come up with an IPO. The money that is required by the company can be for any valid reason – like
• expansion plans, for e.g. Andhra based Deccan Chronicle Newspaper brought its IPO with one of the reasons mentioned as expansion in Tamilnadu region
• paying off its loans/debts
• Investing into research and technology and purchasing latest equipments
• Entering into a new product segment (for. E.g. a floppy manufacturing company may need money to start manufacturing USB Pen drives)
• And several other similar valid reasons that appear to be utilizing money for better performance of business

Ultimately, it’s the investors who have to evaluate the business of the company and then take a decision about whether they should invest in this company or not. The reason for IPO: Requirement for money brings to a variety of options.

The company can take loans from the bank. But, the problem is that the company will have to pay a big interest each month. Also, they will have a commitment to repay the principle amount of the loan as well.
The company can also approach the private investors and ask for money, promising some partnership in their business. But such private investors are very less and it is difficult for companies to convince them and get money.

The simplest and the best way is to get money from the public through an IPO. The company will neither have to repay a monthly EMI or principle amount (like in case of loan from bank) nor will it have to convince the private investors and sell them a major portion of their business. That is the reason why companies choose to list themselves on the stock exchanges, by selling a portion of the company to the public.

Going further, I’m not going to tell you what should you look for before applying for an IPO or performance measurement metrices – but I’ll take an example of a company and explain how your investment in IPO works.

Let’s say there is XYZ Corporation coming up with an IPO with price band 90-100 Rs.. Remember, the markets are efficient and the market already knows about its valuations (as I’ve explained with the example of TCS IPO in my previous article Stock Picking: Good Company v/s Bad Company.) So the better an IPO is, the more it will get subscribed. For the example of Wipro above, 15 million shares are offered for sale to public. If you hear the news that the IPO was subscribed 5 times, that means there were applications worth 15 * 5 = 75 million shares. This usually happens when the market believes that IPO of the company is good. The mediocre companies will have mediocre subscription and the bad companies (as perceived by the markets) will have an undersubscribed IPO – meaning applications received were less as compared to no. of the shares offered for sale.

Continue to part II of this article

IPO-Initial Public Offer – Should you invest in IPOs? Part-2

This is Part-2 of the article “IPO-Initial Public Offer – Should you invest in IPOs?”. Please read the first part of the article before proceeding with this one.

Let’s carry on the discussion for an excellent company IPO, well perceived by the market. Suppose the IPO was subscribed 8 times, which is quite a mediocre figure for today’s IPO offerings. Retail investors like you and me can apply with a maximum of 1 Lakh Rs. Hence, you apply for 1000 shares at 100 Rs. each making it a total of 1 Lakh. You take this 1 Lakh money out of your bank and for the application time duration, it stays with the IPO company. Usually, by the time you get your money back, it is 2 months time.
Suppose you are one of the lucky ones to get shares allotment, you will get only 1000/8 = 125 shares as the IPO was subscribed 8 times. So you will get 125 shares at the price of 100 Rs. costing you a total of 12,500 Rs. The remaining 87,500 Rs. will be refunded to you. Suppose that on the listing date, the IPO had an excellent listing and the value increased 50% (from 100 to 150 Rs.) You decide to sell your shares and book profit. Compared to the allotment value of 12,500, you will get 18,750 from the sale meaning a clear cut 50% profit. You feel happy that you’ve made 50% profit. But is this the right way to calculate the profit?

The fact is that your calculations are based upon 12,500 Rs. Actually you’ve invested 1 Lakh Rs. for this entire investment. So your calculations should be based upon this 1 Lakh Rs. and not on 12,500. So on the 1 Lakh investment, you made a profit of (1875-12,500 =) 6250 Rs. net. On a percentage basis, this translates to 6.25% only (and NOT 50% as calculated incorrectly). However, the good thing is that this profit has come to you in a short span of time, 1 or a maximum of 2 months.

Now, lets look at your 1 Lakh Rs. that you invested. You take the money out of your bank account so you loose interest on it. For people who don’t know, the banks pay interest only on the MINIMUM amount of money in your bank account, between the 10th and last day of the month. For e.g., if I have 2 Rs. in my bank account of 10 July, and I put in another 1 Lakh on 11 July, I will get interest only on 2 Rs. because the minimum amount that I had between 10th and last day was only 2 Rs.
The entire process starting from IPO subscription application to getting the refund takes around 2 months. Even if it takes 1 month, the above mechanism by the banks to calculate interest ensures that you loose the interest for 2 months.

If you had kept them in the bank, you would have earned the 2 months interest. On 1 Lakh Rs. at an interest rate of 5.5%, this comes to approximately (1 Lakh * 5.5% % 2/12 months =) 920 Rs. approximately. On an investment of 1 Lakh, this is just 0.92% return.

Compare this to the return offered by the best performing IPO over the same 2 month period, the IPO with 6.25% returns figures better than the bank interest return of 0.92%. However, one thing to note here is that we are talking about the best performing IPO making a clear cut 50% hike on the day of listing as compared to the issue price.
Here is the list of uncertainties:
• There may be IPOs which may not be able to show a similar performance.
• There is uncertainty about the allocation of shares to you – the more subscribed an IPO is, the less chances you have for allocation.
• IF you end up applying for an IPO that goes in a loss on the very first day, then your investment is worse than what is there in the bank

In essence, the IPO business is not a one way straightforward route, where anyone can say apply for this IPO, and you are sure to get profits. There is always a tradeoff. Good IPOs will get more subscribed, the less chances you have for allotment and hence less profit on your investment. The mediocre IPOs will get mediocre subscription, so more no. of shares, but the price hike on the day of listing will not be substantial. For bad IPOs, you may get all the shares that you applied for, but there is no guarantee of making profits, sometimes you may even have to book a loss.
Let’s have a look at the probability-value calculations for our example of XYZ Corporation:
• Oversubscription: 8 times
• Your probability of allotment: 1/8 = 12.5%
• Your maximum return = 6.25%
• Net Value = 12.5% * 6.25% = 0.78% only.

For the money in the bank:
• Oversubscription: Not applicable
• Your probability of allotment: 1 = 100%
• Your maximum return = 0.92%
• Net Value = 100% * 0.92% = 0.92% only.

Now compare the two investments, you’ll find that money in the bank gives you better returns. However, mathematics and probability calculations work in its own ways; and it is completely subjective and left at the investor’s discretion to decide whether they should apply for IPOs or not. My point of view is that there is no big real benefit in applying for IPOs, even if they give as high as 50% returns compared to the issue price, because there is a cost and risk attached to it. You loose on the bank interest, and there is a risk of no allotment, or a risk of bad performance of the stock on listing. It’s just a matter of luck, if you end up getting good no. of shares in your IPO application and the stocks gets a fantastic opening on the day of listing. If you are willing to take the risk, take it – just remember that markets are efficient so everything that you see is already there in the subscription multiple and the listing price. You should look at applying through IPO if you really believe in the business of the company and hold on for long term.

Keep visiting this blog for further content.
Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

Investment Management Strategies – Part 1

Some time back, Nick (id Nickp2) had left a question in the comments section of a previous article Index fund Investments . What he suggested was as follows:
If I have say a sum of 10 lakhs which I know I would not need immediately.
If I put it in a fixed deposit account in the name of my parents so that the tax effect is minimum.
Now if I ask for a monthly interest option and then invest the interest amount as a SIP in any of the index funds will it be a good strategy of getting good returns while minimizing the risk?


This seems to be a good strategy, though there are some shortfalls associated with this investment strategy.

Let’s analyze this strategy:
He is willing to invest 1 million Rs. (10 Lakhs). He is willing to take the MONTHLY INTEREST option scheme, where the interest calculated for a month is given immediately on the month end. He then takes the interest and invests it in equity market, in any ETF, and keeps his 10 Lakhs as it is.

Basically, this kind of strategy falls under the category of what is called “Principal Protection Scheme”. What nick is trying to achieve is to protect his principal income (10 Lakh) and play around or take risk with the interest that he is going to earn.

Let’s take some realistic figures to understand this: Suppose the interest rate offered by the bank for a period of 30 days is 5% (latest rates available from banks). For people who do not know, the banks offer different interest rates for different tenure of FDs. For an example, here is the interest rate chart from one of the banks:


PERIOD

INTEREST RATES ON DOMESTIC DEPOSITS
%

DEPOSITS

Interest Rate on Deposits Below Rs 15 lakhs

7 days to 14 days

0

15 days to 45 days

5

46 days to 60 days

5.5

61 days to less than 3 months

5.5

3 months to less than 4 months

6

4 months to less than 6 months

6.15

6 months to less than 9 months

7.25

9 months to less than 1 year

8

1 year to less than 2 years

9.5

2 year to less than 3 years

9

3 Years to less than 5 years

8

5 Years upto 10 years

8





Suppose Nick invests 10 Lakhs. At the end of the month, he will receive an approximate interest of 10 Lakh * 5% * (1 year/12 months) = 4100 Rs. approximately. He will then invest this 4100 Rs. to buy Exchange Traded Funds or ETF, and this will go on each month continuously.

Say we analyze the portfolio after 1 year: At the end of the year, what Nick will have is his 10 Lakh Rs, intact in the bank, while he would have invested a total accumulated value of 4100 * 12 = 49,200 Rs. in the ETF, like a Systematic investment Plan (SIP). If the ETF investment grows by 10%, he would make approximately 4920 on his ETF investment, so at the end of the year, he will have 49200 + 4920 = 54120. On the principal of 10 Lakhs, his return is approximately 5.4%. This effective return is way less than the 8% return which he could have received if he had invested the entire 10 Lakh amount for a 1 year fixed deposit, because bank if offering 8% return on 1 year long fix deposit (see table above). Results could have been better if ETF returns are higher than 10%, say 20% or 25%. But then, nothing is guaranteed in the Equity world. If returns can be good and positive, they can as well be negative, in which case the investor would suffer a loss. This is the primary reason why almost all the financial personnel take the return which is above the “Risk Free Rate of Return”. This term - Risk free Rate – is nothing but the interest you get when you deposit the money in the bank for a period of time. Its called risk free because money put in the bank is considered to earn an interest rate without any risk.

Hence, for a yearly return of 5.4% achieved by Nick following this strategy, his effective return (above risk free rate for 1 year) is 5.4% - 8% = -2.6%. In this case, his effective return is negative – which is no way good. Taking the Effective Rate of Return (after subtracting Banks’ risk free rate) gives a value. If this value is positive, then it is wise to go ahead with the investment. If this value if negative (as illustrated above), then its better to put your money in the bank for that period.

However, if Nick decides to carry on this strategy of investment for a very long time, say 10 or 20 years. It is possible that interest rate offered by the banks may come down and equity returns may increase substantially. This may result in a very good profit from the ETF investment – like the NiftyBees ETF has returned a simple average of 70% each year over the past 5 years. (Please read previous post: ETF- Example)The tradeoff that comes is that since the bank interest rates are lower, you will learn less interest – which will mean investing less in equities – which will mean lower value of money in terms of ETF returns. Though there can be periods where both the interest rates offered by banks are higher, and the equity returns are also higher (like what is going on currently). However, there can be no certainty on how long will this situation continue. Ultimately, the market situation changes, both for banks as well as equity markets, and no one can be sure about what’s going to happen and how exactly the returns will come. The best possible way is to protect your principle and then play around with the extra money. First of all, let’s learn to calculate if we can earn better returns just by putting the money in the bank as compared to what we earn from the strategies that we come up with. There is nothing wrong in coming up with a scheme or a model or a system and try to follow it. The part that we ignore is how to evaluate it and how to back test it, whether it works effectively or not.

Across the globe, researches working for investment companies keep on coming up with models and strategies. Before putting it into practice, they back test it and make sure that they understand what they are doing. The first step we individuals should take is to learn this testing and evaluating part.

Another problem with this strategy is that you need big amount of money to put in FD. So that you can earn a substantial interest money. Then you should invest it in such a way that taxes are zero – like investing in the name of retired parents.

However, this strategy is not at all bad. It is one of the very good schemes for principle protection and can be followed religiously. Once I read in the films section of a newspaper (may be a gossip), that “Actor Akshay Kumar has put in 5 Crores Rs. in his bank. The interest earned is sufficient for him and his family to meet the monthly expense.” I would say he has done a wise thing for someone who may not want to get into the hassles of understanding the complexities of the financial world and is looking for a sure shot protection of his money and wants to take care of his living expenses.

This strategy results can be improved substantially once we start looking at the options and futures as an instrument for investment. For that, I’ll have to write the introductory part of options and futures – which will come following this article.


Keep visiting this blog for further content.
Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

ETF – Exchange traded fund example

In this article, I’ll be explaining an example of ETF or Exchange Traded Fund – which is requested by some of the readers. As again, though it will be early for me to introduce another efficient investment strategy, I will attempt to highlight a few practical example of ETF which are trading in the market for some time.

For people who are looking for investment strategies, I have a few questions for you at the end of this article. Please make sure that you respond to those questions by putting your responses in the comments.

Continuing with the article: How are these ETF’s created, issued and redeemed by the investors. Here’s what goes on:

As we all know that ETF is based on an index – like Dow Jones, Nifty or Sensex. ETFs are a bit different from Mutual funds in the sense that ETF units are not sold to the public for cash. Instead, the Asset Management Company (Say UTI or Franklin Templeton) that sponsors the ETF (Fund) takes the shares of companies comprising the index from various categories of investors like authorized participants, large investors and institutions. In turn, it issues them a large block of ETF units. Since dividend may have accumulated for the stocks at any point in time, a cash component to that extent is also taken from such investors. In other words, a large block of ETF units called a "Creation Unit" is exchanged for a "Portfolio Deposit" of stocks and "Cash Component".

Some investors may prefer to hold the creation units in their portfolios. While others may break-up the creation units and sell on the exchanges, where individual investors may purchase them just like any other shares.

ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs for investment, trading or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of underlying index against the price of the ETF units prevailing on the Exchange.

Now, let’s look at an ETF or Exchange Traded fund called – NIFTYBees. This ETF is available for trading on NSE since 8-Jan-2002. On the issue day, the opening price of this particular ETF was 120 Rs, while it closed at 111.55 Rs. Yesterday, on 19th July 2007, the closing price of this NiftyBees ETF stock was 460 Rs. In terms of the percentage gains:

(460-111.55)

------------------

*100

=

312.37%

111.55

The Nifty Index, had a closing value of 1109.9 on 8-Jan-2002; while yesterday, 19th July 2007, it closed at 4562. The percentage gains for Nifty (underlying Index) has been:

(4562-1109.9)

------------------

*100

=

311.03%

1109.9

Compare the returns from Nifty Index (311.03%) to that of those from NiftyBees ETF (312.37%). They are almost exactly the same - with hardly any difference. Moreover, due to the trading activities, it is possible to get a higher value for ETF during the day as the trading proceeds. If you had bought this NiftyBees ETF on 8-Jan-2002 by investing say 1 Lakh Rs., your investment would have grown to a total of 412,371 Rs., giving you a clear cut net profit of 3.12 Lakh Rs. that too in just over 4 years time. It translates to an simple average return of 312/4.5 = 70% return for each individual year.

You would have hardly paid a maximum of 1% brokerage on buying the ETF and another 1% on selling the ETF. That will hardly make any significant difference to your profits.

Which Insurance policy or mutual fund or your own stock picking skills would have given you such staggering returns. I see ads in newspapers – XYZ mutual fund returns 80% in just one year! – what happens the next year? The same mutual fund is not able to keep up its performance – so no ads in the next year claiming excellent profit. Ads that are posted will only be for promotion of mutual fund, not for claiming good returns.

Which Insurance policy, clubbed with returns would have given you such returns – atleast I don’t know of any.

How have your own stock picking skills figured? Were you able to get the same level of profits on your individual investment?

What’s the cost that you pay to trade in ETFs? Hardly a maximum of 2% - 1% on buying, another on selling. Hold them for long term and tax you pay on these will be zero.

I’ve already proven in my previous article

explaining efiicient market hypothesis, that it is impossible for anyone to beat the market consistently year after year. The best you can do is to carry on and go with it, attempting to match the performance of the market. ETFs do exactly that.

Then there are others who say that by investing in so called bluechip companies or top level index based ETFs, we loose on the mid-caps which can outperform the market. For such investors, there is JUNIORBees – a midcap based ETF based on Nifty Junior (comprising of top 51 to 100 stocks).

Have a look at the closing prices of JuniorBees on 11-Feb-04, it was 34 Rs. While yesterday, it was 92.5. The percentage increase has been 172.06% over the period.

While for the same period, Nifty itself has closing value of 1891 on 11-Feb-04 and 4562 yesterday. The percentage gain is 141.25%. Here the Junior ETF has outperformed the main market index by more than 30%.

One thing to note here is that all the ETFs started in India after 2001 period. This was the period where the Indian Markets have seen a major Bull run and hardly very short periods of bear markets. However, the ETFs have been proven to be the most efficient instruments as I’ve explained in the table presented in my previous article

http://invest-n-trade.blogspot.com/2007/07/index-funds-vs-exchange-traded.html> Index Fund v/s Exchange Traded Funds, What’s good Whats Bad?. The best part of ETFs is that you always go with the market.

There was a demand from some readers about a practical example of an Indian ETF. I guess the data presented above should be sufficient to make them understand the working of ETF and it’s efficiency. Readers who may like to verify the data presented here can do so by downloading the data from Yahoo finance or exchange websites.

For individuals who have been asking or are interested in asking about the so called efficient investment strategies, please respond to the following questions:

  1. Are you familiar with the trading and working of derivatives like options and futures? (Yes/No)
  2. Are you familiar with the pricing of options (Yes/No)

Kindly respond, as I will proceed further based upon the readers responses, else I’ll carry on in my own style :- ).

In case your response to the above 2 questions is No, then I cannot explain the next level of investment strategies immediately. I will have to introduce 2-3 articles explaining the working of these instruments and how they can be used to form efficient investments. You can expect the same easy-2-understand articles, similar to the once I’ve posted for introducing ETFs and IFs for http://invest-n-trade.blogspot.com/2007/06/simplest-investment-strategy.html The Simplest Investment Strategy.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

Buying Insurance Policies and Investment Products

Let’s discuss some case studies here:

Case A:

Suppose I give you a choice to make of the 2 available options:

  1. A bet in which you will surely loose 50 Rs. (100% chance of loss)
  2. A bet with 25% chance of Loss of 200 Rs, and 75% chance of Zero Loss

Which one will you choose? Think about it carefully, before making your choice and before reading further.

Some people select choice 1, other select choice 2. What have you selected?

Well, 98% of the people select choice 2 – so if you have done so, Congratulations – you are with the majority. But is majority always right? No, not necessarily, and not always. The psychological reason why more people select option 2 is because there they see a 75% chance of Zero Loss. They believe that there is more chance of saving a loss (75%), and it is better than a sure (100%) chance of loss of 50 Rs. The first illusion that comes to mind is that it is wise to take a 75% chance, rather than a sure loss.

However, mathematics works in its own ways. If we take the VALUE of the above two choices, we have the following:

  1. 100% * (-50) = -50
  2. 25% * (-200) + 75%*(0) = -50

Basically, what this means is that both the options are exactly the same, as far as mathematics is concerned. If someone asks me how much I will be willing to pay for entering this bet, I’ll say 50 Rs for both.

However, our psychological biases force us to look only at the things that we perceive are good, not necessarily the once that are really good. We do not know how to value an investment or a product, the only thing we look at is who is offering the product (a reputed investment bank, fund house or insurance company), who all are talking about and taking the policy (our colleagues, friends, relatives, even agents and brokers) and how has the product done in the past. What we forget is that there MAY not be any relationship between the efficiency of the product with its popularity, and with its past results – like a Mutual Fund performing better in the past does not guarantee similar returns for a coming year in the future. We tend to base our judgments on these factors completely ignoring the realities.

Let me give you another set of options:

Case B:

Let’s say you own a motorbike which you really love. There is a 25% chance that your motorbike will meet an accident and will require repair cost of 200 Rs, while there is a 75% chance that the motorbike will not suffer any accident. So here are your two choices:

  1. Pay Insurance premium of Rs. 50 to avoid paying repair cost of your motorbike
  2. Suffer 200 Rs. loss to your motorbike repair cost (25% chance) or Zero Loss to your motorbike (75% chance)

Which one will you choose?

Again, as in the previous case explained in the beginning of this article, majority (98%) of the individuals choose to take option 1. Hardly a few will select option 2. The fact is both these options again value to the same price.

Now comes the most interesting part: Compare option 1 of Case A and Case B – are the 2 options any different? Option 1 of Case A mentions a sure loss of 50 Rs. while that of case 2 mentions paying an insurance premium. Are they two different? No – they are exactly the same. Similarly, option2 of case A and B are also exactly the same. Yet majority of individuals (including me) end up selecting option 2 for case A and option 1 for case B. The only difference in case A and case B is about the presentation. The same concept is presented in 2 different forms so we end up making 2 different choices. This shows how wrong we are in our perception.

Insurance policies are designed taking advantage of this psychological bias – we don’t see the reality, we end up taking our investment decisions on what is presented to us, not what we need or understand. The job is very well done by agents and brokers. They may not be aware of making profit calculations, or in judging whether this policy is good or bad for the customer, but they gradually become experts in taking advantage of psychological biases and mentioning about the circumstances in which we may need a particular policy. They initially start by telling you why this policy is good and what it can offer – slowly they move to inform you about clubbing the insurance policy with Equity investments, bond investments, regular income, education shield, accident cover, health insurance, tax savings, blah, blah, blah, blah - the list is endless. Rest of the ambience is created by our own wellwishers – colleagues, friends and relatives. They are these smart-alecs who first buy such policies, and then they start advocating about the intelligent investment they have made and also persuade others to do the same by buying the similar policy or make similar investments. In my previous company, there was one such real fanatic “trader”, who would go to such an extent of forcing people to start trading that he would sit with them individually and discuss with them for hours about how good it is to trade and real money is in trading only. He was even willing to schedule meetings with the brokerage firm agents to open trading accounts.

As salaried individuals or businessmen or doctors or other professionals, we find it difficult to devote time to understand these financial calculations. The interesting irony is that these financial decisions are made to secure our future financially – and while buying such products we are the least bothered about the nitty-gritty. Ultimately, it’s human nature – the only thing that can be done is to educate ourselves and use some more presence of mind. We work so hard to earn our money – we leave our money decisions to agents and well-wishers! We get trapped with what is presented and ignore what is right and what we want.

Here’s another common example:

A person will drive in his car for 12 Kms. to buy a DVD Player which was initially priced at 25$ and now being sold at a discounted price of 15$ - he will buy the DVD player that he does NOT want – but is more interested in saving 10$. However, the same person will not purchase a winter coat (that he may really need) available in his neighboring shop for 300$ offering a discount of 10$. The problem is with the so-called “Reference Point”. A 10$ discount on 25$ value looks more in value for something that you don’t need, but the same 10$ discount on an item that you definitely need will not look worth on 300$ price. We tend to look at the percentage basis. 10$ on 25$ is 40% discount, while 10$ on 300$ is only 3.33%. People may already have a DVD player at home, but just because it is offered at a HIGH Reference point discount – they buy it – thinking that they will gift it to someone else or use it later. All that happens is that we end up buying something that we don’t need and avoid buying things that we really need.

However, from the point of view of the seller – he is offering a huge % discount on DVD player because something (15$) is better than nothing. The seller may know that a more advanced version of DVD player may be coming in the market very soon, so the current player will be made redundant. It’s better to sell it off at a lower profit (or even at a loss) to extract something, instead of dumping it in the godowns for no value.

This is exactly what goes on in the investment and insurance business. You become more prone to such marketing gimmicks. The insurance companies put up huge hoardings and place big adverts in the newspapers and television channels – all aimed at disguising the product to be excellent. We tend to ignore that this product may not even fit into our requirements, yet we end up buying them.

Very often I see a 50% discount on sale of 1 Kg. pack of cheese, butter and other dairy products in my local superstore. I’ve seen people blindly grabbing these big size packs of these products – while all they need is hardly 100 or 200 gms pack. The reason for sale is because the expiry date of these products is coming near. If no one will buy it, it will be a 100% loss for the seller. Sell it at 50% discount; atleast the seller gets 50% of the money. What really happens is that after purchasing the cheese in bulk, it may not be possible for the consumer’s family to consume it before the expiry date. A significant portion goes in the garbage bin, nullifying the entire discount. But we tend to buy impulsively – just concentrating on discount.

Another similar experience I had in Big Bazar. It was Saturday, and there was a lot of crowd in Big Bazar. Suddenly, a salesman rings a bell, and announces,” For exactly 1 hour from now, the shirts in this segment will be offered with Buy 2 get 2 Free offer. The offer will end in just 1 hour”. Immediately, people jumped into the shirts section. They were trying to locate the 4 shirts that they can buy – with a tension that they have only 1 hour to select and may be that the best shirts will not be available for long. All that happened was people ended up buying shirts that they didn’t really need, that too 4 of them. The price may have been discounted, but the sale of 4 shirts ensured that big bazaar managed to sell its products. Nothing but IMPULSE MARKETING.

The same goes on for selling insurance products and investment policies. We tend to take decisions instantaneously. We never take time to analyze and IPO or a NFO – just that the IPO or NFO is opened for 3-4 days, we pour in our money. Same goes for insurance policies which are sold at the financial year end –with the tax-saving keyword doing the magic (as I’ve explained in one of my previous articles).

Sometimes, the agents are even willing to give cash from the portion of their commission. Most of the times, these cash offers are made for policies that require a long term commitment from the investors. All that is required by the insurance company and the agent is that the policy should be sold, the customers should commit for a long term – that is what makes LIC the biggest player in the Indian stock market.

Continuing from the past 2 articles, I believe I’ve written enough against the agents :- ) The only thing I want to convey is understand the policy or product that you are buying. Learn to read the fine prints, try to understand whether it is what you really want or is it just going to be another impulsive purchase for you. An example I’d like to quote here is in the Comments section of my previous article. Please read the queries left by Shashi in the comments section for her policy and my detailed responses to it.

Keep visiting this blog for further content.

Please read the comments and post your views in the comment which helps in open discussion.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.



Insurance v/s Investment v/s Tax savings – agent based business

Let me continue further with Part II of my previous article. In case you’ve not read my previous article, please read it before continuing with this one.

Let’s begin with a question: Who is the biggest investor in the Indian Stock Market? Your options are:

  1. Foreign Institutional Investors
  2. High Net worth Individual
  3. Life Insurance Corporation of India (LIC)
  4. Banks (Foreign or Indian)

The answer is option 3 – LIC. The amount of money LIC collects as insurance premium is huge, so huge that it makes it the biggest investor in the Indian market, beating all big foreign fund houses. Depending upon the policy you take, you may/may not be guaranteed a return. For them to generate a return and pay for their employees and agents, they need to invest the money and make profits. If they promise some specific amount at the maturity, the policy makes sure that the admin charges are big enough to compensate for the returns. Individual Investors end up receiving a slightly better return than what the banks FD offers. That’s a fact. The problem is that individuals don’t know how to calculate the profits on their investments. That’s why the very first article that I’d written, was aimed at giving a brief idea about calculating the profits.

The biggest problem is with the ignorant investors and these agents – neither the investor knows what he wants to achieve (tax benefit, insurance or investment) nor is the agent interested in customer’s benefit. All he needs is a SALE of one such policy, which earns him a commission. Visit the career section of website of LIC India, the eligibility criteria for becoming an agent is as follows:

  • 12th standard pass
  • Age 18 and above

That’s all it takes to become an agent. Same may be true for other insurance companies. It’s true that agents may even have Bachelor’s or Master’s degrees, but the minimum required qualification indicates what kinds of people are suitable for an agent’s work. They don’t even need a basic commerce or economics background – anyone with 12th standard (Maths, Biology, Arts) will do fine. Most of the readers of this blog atleast have a bachelor’s qualification, yet we end up believing these agents, thinking that they know better than us and they can suggest us better solutions.

Last year, a relative of mine celebrated the 3rd birthday of his kid. He wanted his kid to become a doctor like him. After the lunch party, he told me that an agent is visiting him in the afternoon, as he wants to buy some education shield policy, so as to secure the medical college fee. Around 4 pm, an agent walks in with a briefcase which carries a calculator and some pamphlets of investment plans.

Very nicely, the agent explained the benefits of the education shield policy and was continuously attempting to tell my relative how important it is to secure the education money for the kid. He was repeatedly using the sentences like “How will you feel when your meritorious child will secure a seat at the Medical Entrance exam, and then you’ll discover that you are short of money” and “Suppose your kid cannot secure a free seat, and he needs money to take a payment seat or donation seat, that is the time this policy will help”. The investment horizon was 15 long years. During the half an hour of his explanation, I kept quiet, while my relative was getting puzzled with the 3 policies that he had short listed. He finally asked the agent to tell him which one to choose. Nowhere during the conversation did the agent mentioned how much will be the admin charges and what actual profit will my relative make by investing in this policy – probably he doesn’t know how to make the calculations. He finally suggested one policy, claiming it to be the best. My relative finally nodded and said, “OK, on your words, I’m taking this policy”.

Till that time, I was sitting quite. I could not understand why did my relative asked me to wait when he had to take the decision on his agent’s will. However, the deal was finalized. My relative committed a certain amount of money each month, for the next 15 years, to get an assured return at the end of the 15 year horizon.

This situation is quiet commonly observed in our daily lives – at home, shop, office, sometimes even at coffee shops. We see/hear about such policies, call/meet the agents and end up purchasing something that we don’t really understand or better to say we may not even need it. Agents will be after you for everything, for tax planning, for insurance, for policies giving death benefits for your loved ones, for hospitalization, for education for your cute little ones. People call it investments and savings, I call it PSYCHOLOGICAL BLACKMAILING.

I’m NOT against these policies or these agents – It’s a business, someone has to do it. But I’m against the ignorance and faulty decision we take based upon the agent’s advices. Some policies are really good, but our decisions are influenced by what the agents want to sell, and obviously they want us to buy somethings that earn them more commission, not the ones that are right for us.

One of the professors during my lectures at Rotterdam School of Management described the working principle of these agents in the following way:

If I am not gonna sell my crap policy to this customer, some other agent will sell other crap policy to this customer. So let me sell my crap policy to him and earn my living (commission)

My Professor later continued with the following - “The same can be carried on for the following phrase on similar lines”:

If I am not gonna rob this person off his money with my gun, someone else will rob this person off his money with his gun. So let me rob this person with my gun, and earn my living

In essence, the person will be robbed, either by this agent (robber) or the other.

I know, and I agree, that this was something really at an extreme end :- ). However, this shows the truth about the world of brokers and agents. In all my articles, I’ve always talked about the HUGE size of the market. It’s equally true in the world of agents. People are just waiting for profit making opportunities, and the same goes for the agents and brokers as well.

Once the agent left, the reaction of my relative was as follows: “Bahut dino se kuch to lena tha, so le liya (I was waiting to take some policy since a long time, now I’ve taken one)”. Even after paying, he didn’t know what he had bought.

I picked up the visiting card of the agent that he had left. It had 4 logos - LIC, ICICI Insurance, Sundaram Finance & Bajaj Alliance. He was in the business of selling anything and everything – same is true for other agents as well. The next day, I called up on his cell phone. I asked him for a similar education policy that my relative had bought. He insisted on meeting me personally, but I continued the discussion on the phone. I asked him how much will be the cost of medical education 15 years down the line. He had no answer. I asked him what is the cost of medical seat (free, payment, donation) as of today, he gave me a vague range (“Sir, I don’t know but it can be anything from 1 lakh to 8 lakhs). Continuing further, I asked him, “If it’s such a wide range, which policy should I buy and for how much?” His answer was, “Depending upon your budget, you should invest. I’ll help you once we meet”.

The conversation stopped there. The agent had no idea of medical education fee even as of today, yet he’s willing to sell the products for 15 long years. Now let’s look at this real life case in detail:

Purpose: What does my doctor relative want: Security for his kid’s education fee.

How much will be the education Fee 15 years down the line: UNCERTAIN

How sure is the choice of career path for the kid: UNCERTAIN

Returns of the selected policy: CERTAIN sum of money depending upon how much you CONTRIBUTE. YOU have to decide HOW MUCH to contribute. Does this serve the purpose of education shield policy & will that be sufficient at that time?

Right from the purpose & investment of this policy to the career path that his kid will finally choose, nothing is certain. Even after buying the policy, a doctor himself does not know whether he did right or wrong, though he is from medical stream and wants to serve a purpose for a similar stream. What he gets is a RUPEE VALUE of money, which may or may not be sufficient to fulfill the purpose. Depending upon the budget, he has to decide how much he should invest and for how long. He has to make the prediction about the cost of medical fee. And he is the one who is most ignorant about the risks, uncertainties and the products. I made the time value calculations for his investments. After investing so much and for so long, he got nothing better than the return offered by Bank FD.

My readers have been complaining that I’m too pessimistic with investments. So let’s also have a positive outlook now. Suppose that my relative made investments predicting the cost of medical education to be 1 million (10 Lakh Rs) at the time when his kid is eligible for college admission. So he invests x amount of money each month, to get 10 lakhs at the end of 15 years. However, the meritorious kid manages a scholarship and he can complete the MBBS course with just a living cost of 1 lakh. My relative will definitely feel happy as his investment saved him enough money (9 lakhs). But even though he saved money for the future, it comes at a cost. To invest in such a policy, he may have to cut onto certain other expenses for today. May be buying a better car is foregone today, may be moving to a bigger apartment is foregone today, may be a world tour is postponed today, so that his investment for his kids future is secure. Everything comes at a cost. At the time when his kid will be eligible for admission, my relative would cross 45. At that time, despite saving money on his investment, he may repent foregoing a luxury car, a better apartment, a world tour – for which he may not be excited after the age of 45. Be it investments or anything, everything comes at a cost in the present.

If something is not understandable by me, and I’m not able to identify whether my long term investment will suffice my purpose, should I invest in such a policy? Well, atleast I will not do it. I’ll prefer continuously investing in ETF’s or IF’s, as monthly systematic investment plans. If my investments with such policies are “Subject to Market Risks”, I’ll better take market risk on my own by investing in low cost ETF and IF. The fact is that everything is uncertain. If you like to take risks, take it in a systematic way, which does not attract any commissions or high brokerage. Don’t get trapped with the jazzy titles of policies – they are not designed to serve your purpose. If you are risk averse investor, go for bonds, Bank FD’s or PPF account. The choice is left to you, depending upon your risk appetite.

If you fear that your death will cause a calamity for your family and want to buy insurance, buy a death benefit policy. Don’t club it with returns – better take a policy with benefit/returns only in case of death/accident. It’s like throwing your money in the sea and not expecting anything. What we end up doing is taking a mix of policies – clubbing death/accident benefits with returns or tax savings. That is what takes us to the wrong path. Tax-saving buzz word adds to it. It is important to know that insurance should be taken as insurance, not as investment. If you want to invest, invest in investment products (Stocks, Bonds, ETF, IF, PPF, etc). Avoid clubbing the two. Once you start looking at a combined mixed policy, you end up focusing on returns. What you forget is the admin charges and commissions.

After reading my articles on ETFs and IF’s, some readers have asked me to recommend which ETF or IF is better. Well, I am criticizing agents, brokers and their recommendations, and I don’t wanna be categorized as one of them :- )

I am writing with an aim to tell you what’s good and what’s bad in a particular product or strategy. Which brand do you want to buy is left to you.

Keep watching for further content.

Buying Insurance Or Pension Plan for tax-savings

Tens of insurance plans, Pension Plans (Retirement Plans) and health policies are available in India for purchase. Additionally, they also give you the implicit tax benefit, i.e. the premium you pay – i.e. the amount you contribute towards them – is exempted from tax. Looking at the way people keep talking about the tax and tax-saving issues, it seems that taxation is one of the biggest problems of the salaried individuals. Some day or the other, individuals end up buying some such policy. However, the primary purpose of buying such policies is not investment and security for future, but savings of tax. In this article, I’ll try to highlight some of the fine details of these different investment tax saving schemes.

In almost all of my articles, I could not control myself from partially touching the psychology of investment and trading. In each article, I’ve very briefly talked about the way people behave while taking financial decisions – be it trading or investing or buying things. One thing I want to stress here is that I am not a good student; I don’t like studies very much. When I finished my Bachelors in engineering, I had no idea that someday I will be going for Masters that too with specialization in finance, investment and trading. I went to a management school thinking that I will specialize in stock trading and make enormous amounts of money. However, the most interesting topic that I liked during my finance studies was behavioral finance. Though I don’t have any plans of studying further as of now, but in case I go for further studies, it will be a Ph.D. in behavioral finance :- )

The reason for quoting the above is that the issues of taxation, insurance, retirement planning, or buying education policies for your beloved children, are all driven by psychological biases. The ambience is created by the so-called AGENTS, who are ready to knock at you door or call you on your cell any time during the 24 hour period. All they are interested in is their commission. What they sell to you is not their recommendations, but their headaches of earning a living through commissions that they earn for sale of policies. TAX SAVING is the biggest buzz word used by these people finally making you feel that it is important to save tax and buy some such policy.

A brief introduction to the following:

  1. Insurance Policy: Invest monthly/quarterly/six-monthly/yearly/one-time
    1. Returns in case of accidents
    2. Returns in case of loss of life
    3. Returns upon maturity of policy
  2. Pension Policy/Retirement Policy: Invest monthly/yearly
    1. Returns in lump-sum when you retire
    2. Returns as a monthly income when you retire till either 75 years of age or till your death
  3. Education benefit policy: Invest for 10/15/20 years
    1. Returns as lump-sum amount when the child is eligible for entering the college – aimed to pay for education fee
  4. Health Insurance: monthly/quarterly/six-monthly/yearly/one-time
    1. Refund of Hospital bill charges in case of hospitalization

Most of these plans, from LIC, ICICI Prulife, BAJAJ Alliance, HDFC and other insurance firms come with an additional benefit of tax saving! This is the buzz word that makes you buy them.

But are these investment options or better to say tax-saving options, really worth considering?

Have a look at what I did in 2003. It was February 2003. It was the time for financial year ending and I received the consolidated tax-sheet from the accounts department – showing a high amount of income tax, which made me worried – why should I pay such a high amount of tax, when there are so many tax-saving options available! The situation in my office among colleagues was similar. Irrespective of the high salary we were earning, we still could not digest the slightly higher amount on the tax-sheet. Result: One person calls the insurance agent and all of us line up to talk to him.

Very smartly, he introduces us the ICICI Prulife Pension policy, dictating us the benefit of tax-saving. Invest 10K, save 30% tax as 3K, your money managed by PROFESSINALS, so good returns guaranteed. What he did not tell us was that a significant portion of money would go as ADMINISTRATION CHARGES. When I, and many more colleagues, bought this policy, this was the state of administrative charges:

Policy Duration: 25 years (can be withdrawn after 3 years)

Admin Charges:

Year 1: 18% (Yes, that’s right – 18%. For 10K investment, that means 1800 Rs. goes towards admin charges, so effectively only 8200 Rs. are invested for you)

Year 2: 10%

Year 3: 7.5%

Year 4 onwards : 4%

Recently, I heard that the first year charges for the same policy have been hiked to 20% (not very sure about this)

So, when you buy this policy, you may save 30/20/10% of tax, depending upon your tax-bracket. However, even with 30% tax bracket, 18% is gone in the very first year. That leaves you with only 12% benefit that too with a lock in period of 3 years.

In case I decide to withdraw my policy after 3 years, I invest 3*10K = 30K. I get tax benefit of 30% = 30% * 30K = 9K. However, I pay a total of 35.5% of tax, averaging to almost 12% each year. It means that when I pay 10K each year for minimum period of 3 years, of my 10K, only 8800 Rs were invested. Remaining 1200 were taken up by these GENTLEMEN who manage my money PROFESSIONALLY. At the end of 3 years, though I invest a total of 30K, my actual investment is only 8800*3= approximately 26.4K Rs. I gain 30% on tax savings, which amounts to 9K, bringing the total to 35.4K Rs. Now, ASSUMING that the managers managing my investments give me a mere 5% returns each year.

So my investment in this policy will grow as follows:


Previous Year Carryforward (a)

This Years investment (b)

Total Investment (a+b)

Return

Total Return

Year 1

0

8,200.00

8,200.00

5%

8,610.00

Year 2

8,610.00

9,000.00

17,610.00

5%

18,490.50

Year 3

18,490.50

9,275.00

27,765.50

5%

29,153.78

Hence at the end of 3 years, I will have a total of 29154 Rs, if my manager gives me a return of 5%. Add to this the tax benefit of 3K each year, amounting to 9K, then the total becomes 29154+9K = 38,154 Rs.

Following a simple average concept, my 30K has become 38.154K, giving me a total return of 8,154 Rs in 3 years, and simple average over 3 years = 8154/3 = 2718 Rs., making it a 27.18% average return.

Now have a look an alternate investment in Tax-saving infrastructure bonds. There are NO Admin Charges at all. All the 10K you invest, will get invested fully. Assuming a very low interest payment of just 5%, we have the following table for Bonds:


Previous Year Carryforward (a)

This Years investment (b)

Total Investment (a+b)

Return

Total Return

Year 1

-

10,000.00

10,000.00

5%

10,500.00

Year 2

10,500.00

10,000.00

20,500.00

5%

21,525.00

Year 3

21,525.00

10,000.00

31,525.00

5%

33,101.25

So at the end of 3 years, I will have a total of 33101 + 9K (tax benefit) = 42101.00 Rs. Over my invested value of 30K, I made 12,101 Rs. Simple average for 3 years gives me 12101/3 = 4034 = 40.35% of returns each year. Compare this 40.35% to the returns generated by ICICI Prulife policy (27.18%) it is way better than the Pension Policy.

Now, the question is of returns. So lets increase the returns to 20% for the policy. We get the following table:


Previous Year Carryforward (a)

This Years investment (b)

Total Investment (a+b)

Return

Total Return

Year 1

-

8,200.00

8,200.00

20%

9,840.00

Year 2

9,840.00

9,000.00

18,840.00

20%

22,608.00

Year 3

22,608.00

9,275.00

31,883.00

20%

38,259.60

Total: 38259 + 9K = 47,259.

Total returns = 17259.

Simple yearly average: 17259/3 = 5753 = 57.53%

This is the BEST case scenario, where the return generated by the Professional Managers is supposed to be consistent at 20% each year. This case performs better than the bonds. However, the market does not work in this way. No body can consistently guarantee sure shot returns, as I’ve explained in my previous articles. How about the risk that you have taken for this policy as compared to the RISK FREE BOND investment? Is it really worth taking a risk into uncertain future, especially when the managers are pocketing a hefty fee for managing your money?

Are they really guaranteeing even a 4% return (equivalent to their minimum commission)? OR even the guarantee of principle protection?

Also, your bonds will mature in 3 years time – for sure. You invest in 1st year and then decide not to invest in 2nd year – that is possible in bonds. It is NOT possible in the policy, atleast for the 1st 3 years you will have to keep investing.

Some of my friends have invested as high as 50K each year. All they ended up with was the tax-saving policy, with a commitment to invest 50K each year, for the 1st 3 years.

I have nothing against the ICICI Prulife policy makers, or any other organization offering such policies. I am attempting to highlight the problems and highly uncertain returns (even losses) from these investments for tax-savings (especially as compared to the Risk free bond investments offering similar tax benefits).

Interestingly, despite so much long term commitment required from the customer’s side, the financial organization does not offer any guarantee for returns. For people (like me) who have bought ICICI PruLife policies, I’ll suggest them to have a look at the policy statement (either online or in paper form). It will have a section for “SUM ASSURED” – basically indicating the sum assured at maturity – i.e. after 25 years or when the person decides to terminate the policy. Here is the screenshot of my online statement:



In my policy, the SUM ASSURED is showing as ZERO. They are taking 18%, 10%, 7.5% and 4% charges from me, still all I’m assured is ZERO. Go to the homepage of ICICI Pru Life (www.iciciprulife.com). The logo carries the punch-line: “We cover you, at every step in life”. My policy may run for 25 years, they assure ZERO amount on maturity and “Claim to Cover me, at every step in my life” . On the same homepage, in the bottom right corner, you’ll see an animation that carries the following words: “Education guaranteed, Retirement guaranteed, Future guaranteed” . The latest TV ad has he punch-line “Jeetey Raho” – Keep Living. The best way I can describe this is “Keep Living (under the false assumptions of making good returns), and Keep Paying ADMIN FEE to the PROFESSIONAL MONEY MANAGERS” .

Another interesting part is that I have recently sent them a mail, asking them why this sum assured showing as zero despite my policy running for so many years. Usually for all other queries, I’ll receive a response within 2 business days. However, for this particular query, all I’ve received is an automated mail, mentioning that my question has been received. Despite 2 reminders, I’ve not received any response. Fortunately, the automated response also had a call no. assigned to my request, so atleast I have a proof in my mailbox that they have not responded to a valid question.

I’m sure individuals would have had similar experiences with other policies from other organizations. I’m not against these organizations or their policies – it’s a business, they have to do it, they have to pay to agents, fund managers, advertisements, etc. It’s the uneducated and unaware investors like me who are responsible for our investment decisions. If instead of buying this policy, had I bought ETFs on Sensex, I would have been much-much better off. The policy states: Investments are subject to Market risk. I believe its better to take market risk on my own on the entire market, instead of paying such a heavy commission to someone else without any guarantee. If I am risk averse investor, then tax-saving bonds would have been a better option –atleast sure shot fixed interest would have been guaranteed.

Now comes the question, how about the tax-savings??? If you have to invest for long term, better invest in bonds year after year. The best part it you can discontinue it whenever you like. You don’t have to commit a certain sum each year, if you want to continue your investment – You can invest the amount you wish. OR take PPF account – Prulife policy is for 25 years, PPF is for 15 years, that too with a fixed interest rate of 8.5%, so no risk, yet guaranteed returns. Also, no one is going to ask you for the source of income and the interest in PPF is not taxable. Want some more better return from stock market in the long run, go for ETF’s or IF’s. Long term capital gains tax is Zero. You will win on all the fronts, provided markets go up in the long run. You may not be able to save tax on ETF’s and IF’s, but is you really wanna benefit from the stock market, their returns in long run will be much better than what you save in taxes.

So what’s the point in paying commission to others?

Part II on the same to continue


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