19 June, 2012

Chasing hot products will get you nowhere...

We are a cinema crazy country. What our heroes & heroines wear & flaunt, become a craze overnight.  You can get your “Aamir cap”, “Shahrukh coat” or “Kareena  salwar suit” which was featured in a recent movie, in shops across town. You will find half the town wearing the latest hot fashion, though!

Chasing the latest fads does not end with our sartorial sense alone. Even in one’s finances, we tend to choose the latest, hottest product.  So, if all in office are procuring a particular insurance policy or are going for some investment plan, it becomes the basis of investment itself, without any further thought. Thought is not given as to whether the product is suitable for them in terms of the asset class, duration, liquidity, risk profile of the product, end use and other factors.

The other fundamental problem is that different products perform at different times.  Fixed income securities give good returns when the interest rates peak. But logically, when interest rates peak, economy and it’s constituents – the businesses, tend to underperform due to the higher cost of capital.

The right time to invest in an asset class which displays up and down cycles is when it is down, not when it is at it’s peak.  Investors tend to invest when the market is in the middle of a bull frenzy, which is like sowing seeds in the middle of the rainy season.  The crops grow properly only if the fields are prepared and seeds sown well before the rains so that the saplings are ready to receive the bountiful rains and grow in lush profusion.

In case of products which are prone to cycles like equity, real estate, property etc., it is very difficult to divine the bottom point, at which to invest. The psychological aspect comes into play here. When the markets are bottoming out, the investor expects it to go down even further. But contrary to expectations when it starts rising, they expect a dip again as the lowest level is their anchor now and anything above that seems expensive. When the price has moved up and away, the investor realizes that they have missed the boat. They wait even more. When the markets move further and there is a frenzy, they come in. Soon after, the markets tumble as they have come in at the height of a bull cycle. They retreat into a shell and want to invest only in fixed income products from then on. Investments done at the height of the markets take very longtime to recover. This happens as we want to time the investments and want to chase only those that are giving good returns, at that point. Paradoxically, we end up getting poor returns when we are gunning for products that give good returns all the time!

Chasing returns like this will ensure that one ends up buying equities, real estate, gold etc. at inflated prices, as investors tend to buy when they are performing. Pulling money out from “non-performing assets” like equities now and channeling them into “performing” assets like FD, Gold, Real Estate looks like the path to nirvana. Actually, they are setting themselves up for future failure.

Investing too much into fixed income securities alone also exposes an investor to undue risks. Fixed income products mostly do not give positive inflation adjusted positive returns. This means that the corpus that one needs for any future goals will have to be accumulated with higher savings contribution, to reach the same goal. Also, retreating into the shell and not willing to commit resources to cyclical assets at the bottom of the market ensures that they do not reap the rewards of the upcycle.

Equity markets, especially, are driven by fear and greed.   Investing only when it is rising is a sure recipe for poor performance of one’s portfolio.

Investing in products which are doing well at that moment also does not address several other aspects that need to be taken into account while investing.

The first is that one needs to know why they are investing in a product – what is the end use for it. Without a proper goal, an investment tends to be fuzzy.  A product invested without much thought, may be a long-term one like property, but the requirement may come for it after a year. In such a situation, there is a huge mismatch between the product characteristics and it’s end use. Hence, one should at least classify whether a product is for short-term needs or for the long-term goals. That way, one would invest in an appropriately oriented product.

Secondly, one needs to invest for an appropriate tenure. Some products offer good returns only over time. Correct tenure for an equity product may be five years. Now, if it is invested for a couple of years and redeemed, it may give poor returns.

The other aspect is liquidity. Investing in PPF may be a very good idea for someone who is accumulating a corpus for retirement.  However, it may not be suited if the amount may be required for daughter’s admission, two years hence.

This is the classic problem. The product may be good in a lot of cases but may not be useful if it is not properly matched. It is like mating a low powered engine to a sports car. It is just the wrong kind of engine for a sports car though there is nothing wrong with the engine itself.  It would be perfectly at home in a small car.
The simple solution is to diversify one’s investment basket. That way, one will not end up with one kind of product alone and lose out on the potential that other products have. The other solution is not timing the investment and investing across cycles and time horizons. If one also rebalances assets and sticks to a predetermined asset allocation, it will work wonders. 

It requires guts to put in more money into equities at the bottom of the market, like what Warren Buffett did in 2008 & 2009. But, he is no ordinary investor. He does not chase fads. He is after good investment propositions – which he got at the market bottom. Time for us to learn from the master – that buying in times of distress is the correct investment strategy and investing while there is a frenzy is a slippery, glacial slope to nowhere.

Article published in Business Standard on 17/6/2012 by Suresh Sadagopan

03 June, 2012

Providing for emergency/ liquidity

Liquidity management is one of the most neglected areas of one’s finances. Most people tend to think that liquidity management stops at maintaining a sufficient cash balance in one’s savings account. Some maintain fair amount of actual cash itself.

Both of the above may not be the best way to maintain one’s liquidity. We need to maintain liquidity to take care of the current expenses. Also, a margin of safety needs to be maintained. For that purpose, a liquidity margin is to be maintained, which would typically cover three to six months expenses. Three months expense cover is good enough for most people. Six months cover is suggested when the earnings outlook is uncertain. Also, it is suggested when incomes fluctuate, due to the nature of their job itself ( say a TV artist or someone in a sales function where the commissions fluctuate ). For some, even the expenses can be variable on a monthly basis. A higher liquidity margin will provide the additional cushion, in such cases. Also in cases where there is a loan and an EMI is being paid, a higher liquidity margin is critical.

Liquidity can be maintained in one’s bank account to the extent of what one may reasonably require for expenses, plus some. Since savings bank account offers 4-5% pa interest pretax, it is not the most desirable of places to park one’s money, beyond the absolutely necessary level. Since, the liquidity margin may not be touched for the most part, we need to invest in a place which can offer better returns than a savings account. One of the places where such funds for liquidity can be maintained are sweep-in deposits, which are available in a bank. These offer far higher returns as compared to savings bank account. These deposits get created when there is more than a certain amount of money in one’s savings account. For all practical purposes, the amount in flexi deposit is like the money in the savings account, as they are available for withdrawal anytime, as an when required.

The other desirable place to park the liquidity amount is in ultra short-term funds.   These funds offer good returns of over 9%pa. What’s more, the tax treatment here can be far more benign… if invested in the dividend option ( which would be the correct choice ), the dividend distribution tax is at 13.5%. For a person in the highest tax slab, this will translate into major savings. Ultra Short-term funds do not have exit loads or have for very short periods. Hence, when required, they can be cashed out and used.

We would also be planning for events which are going to come up – like an upcoming premium payment, holiday funding, annual school fee payment etc.  To meet them without problems, we would have to create provisions for these events which more or less are certain. The other situation for which we need to plan for is a contingency. Contingency is an event which can happen, but the timing is uncertain. An example of contingency is a medical emergency. Or it could be a financial emergency of a dear one, which needs to be met.
In both these cases, we have a variety of instruments to contend with. Since the tenure is known in case of provisions, we can invest in an appropriate instrument. For instance, if an expense of Rs.50,000/- is coming up 4 months hence, one can invest in a monthly interval plan and roll it over till it is required. If an expense is coming up in about 3 months, a quarterly interval plan ( QIP) would be more appropriate. At current rates, even an ultra short-term fund would be a good bet.  For somewhat longer tenures – say one year – a Fixed Maturity Plan ( FMP) of a similar tenure would do the job.  If the timing is rather uncertain, one can invest in a QIP and roll it over, till it is required.

For contingencies, the timing is uncertain. Hence, investing in somewhat longer tenures is actually desirable. Many instruments present themselves for this. However, care needs to be taken that these are not invested in locked-in instruments, which cannot be easily liquidated ( eg. FMP ), when required.  Also, only a small portion should be invested in instruments whose value can fluctuate like equity, as, if they cannot be liquidated when necessary as one may incur a loss, it beats the very purpose of a contingency fund. However, a contingency fund may remain unused for years on end. Due to this, investing a small portion into instruments which can potentially give good returns in the long-term is a good idea. One should restrict the investments to 20% of the portfolio.

Bulk of the investments can be in instruments which give stable returns and which can be liquidated. The instruments which lend themselves well for such investments are debt funds from the MF stable & FDs. Debt funds from Mutual funds that are chosen for this purpose can be short to medium term funds. Dynamic bond funds, Short term funds & medium term funds  ( with average maturities of between 1.5 – 4 years ) can be looked at. FDs from banks are more suitable for contingency funds as liquidating them and getting the money into their bank account may be far simpler than if it were a company FD.
Get yourself the advantage!

In sum, though investing for goals & other objectives are important in one’s financial plan, liquidity margin, provisioning & contingency funding are very important too. By investing in the appropriate instruments, one will be able to build a cushion as well as earn reasonable returns from such funds too.