Medical Insurance with Money Back plan

I live in a world where each passing day my medical bills keep increasing, sometimes due to bad life choices and sometimes due to corporate avarice. I pay our annual insurance bill out of my salary, and keep my fingers crossed that nobody in the family falls sick. Also I know how difficult it is to get insurance claims sometimes - claims denied, claims not paid on time, coverage not applicable to our elderly parents who need it the most. Lately I have also realized that the coverage offered by our company doesn't seem enough so I have been mulling over a "top-up" medical insurance.

So after mulling over it some, I had an epiphany that would allow me to sleep more peacefully and yet will take care of the medical needs of my family in the years to come.

What industry benefits when we fall sick? Pharmaceuticals. What industry benefits when we want to stay healthy? Pharmaceuticals. What industry benefits when we want to become fitter? Pharmaceuticals. So the epiphany I had was why should I not buy some pharma stocks and gain from their gain? The question that came back is how profitable would it be? Will it compare favorably with getting medical insurance? Is it possible to beat the insurance coverage provided by the health policies. Well, as it turns out, its not easy but it can be done - not in the short term but definitely in the long term.

I am not that well versed with financial statements and all the "research" tools adopted by my friends who work in core finance. But I do have the common sense to look around and find out which are some of the decent pharmaceutical companies. Also my family has some connection with pharma industry. Based this amateur knowledge I went looking for pharmaceutical companies and picked up two randomly - Cipla and Sun Pharma - and ran some numbers.

I first take the stock price of these companies every year for the last 10 years on Nov 25. I then buy stocks worth 10000 every year. Here's what I found. For an investment of 1,00,000 over the period of last 10 years, Cipla is currently worth 2,71,000. That's a 11% return compounded annually over a decade. That's probably the medical cover provided by my group life insurance. If by some chance I had instead picked up Sun Pharma the current value would have been 6,87,000. That's a 21.5% return over the last decade. And certainly more than any medical cover given by any group health cover.

On the other hand if I had disregarded medicine and was more of a believer in general health and fitness, I should've recognized Horlicks, Eno, Iodex, and others. For the company is called GlaxoSmithKline and the same 1,00,000 over the past decade would have returned me 7,14,000. An even nicer 21.8% annually. And all these are excluding any dividends. Plus these are long term gains so I don't pay any taxes.

Now here's the zinger. This is money just in a decade. Over 4 decades out compound like crazy. No medical insurance policy will ever match it. It becomes ever more important because as we grow old insurance becomes costlier. After a certain age I may actually find it difficult to get insurance. But this investment can become much more than that. And if I keep healthy this money is mine to keep - a money back policy.

And do check my calculations if you will. Here's the link https://docs.google.com/spreadsheets/d/16YDhZVTFT-GcOi_-gq1KgZHVjatC6iPxDy5KEpPF_kk/edit?usp=docslist_api

Purchasing Power Parity

We have on varied and multiple occasions breathed long and vocal sighs when we hear the large dollar/pound/euro salaries and benefits that our very close and dear friends earn when they work in developed countries like USA, UK, Netherlands, Australia, etc (at least I do this purposefully on every occassion :)) What we tend to dismiss with the wave of our hand or the flick of our finger is their living expenses based on a certain minimum lifestyle in such countries. Obviously this applies to people who have stayed back for some duration like for say 4-5 years and not the other set of friends who were there on a short stay (how they behave is beyond of the scope of discussion in a blog post!) And this is where we should think of Purchasing Power Parity or more commonly known as PPP.

PPP: In simple terms it is difference in cost of a Big Mac at McDonalds in your native country vs. in the foreign country you are comparing to. Or you could say it is the cost of a meal/ movie/ party/ car/ house/ etc. in the countries you are putting in the comparison bucket. Again always look at averages across items, and across geographical regions within each country. So the coffee your NRI friend buys for $4 you can very well buy for ₹25 here - its like saying that the value of $4 is the same as the value of ₹25.

Are there any standard measures: Not really. Over the years various economists and organizations have tried to do something in this direction without much success or recognition. Although the Big Mac Index has some popularity in this matter - it was first popularized by The Economist. It essentially tracks the price of a Big Mac produced and sold across 120 countries that have a McDonald's outlet. Since this burger is a standardized product it is very loosely indicative of PPP or currency under/over valuation. Again, it is not a serious economic indicator, as in no country would probably base its economic policy on this. But it comes in handy when you want to write a post like this !

Why should I be bothered: Well, we probably wouldn't even use it in our day-to-day life unless you are economic policy advisor to the Government of India. But it helps to look at things in perspective, and realize errors in leading media articles like this on TOI today. I usually am wary of our media - half the time their content and the journalistic quality is such crap such that I cringe to pick up the morning newspaper. Some have gone so bad that their editorials come out as incoherent jingoistic babble in favor of the babus and netas. But this particular piece takes the cake pretty near the bottom. Aren't newspapers supposed to raise awareness about issues that people are concerned with ?? And not mislead the junta ??

Oh, by the way, my favorite newspaper is "Bangalore Mirror" - flawless and entertaining in their coverage of storm drains, petty theft, celebrity sightings, and your sex problems! What more can you ask for ??

Inflation and Expenses

Everybody has variably heard of the word inflation. As a matter of fact, any educated person would like to rattle off his/her knowledge on inflation, and with the current market news (maybe I follow it a bit too much) its all over. So here's a small peek into what is it and how it affects us.

Inflation: In simple terms it is the phenomenon due to which the little orange candies which used to cost 10paise each back when I was a kid at school, now cost more than 50paise (on a conservative estimate). Or the onion butter masala dosa a south Indian delicacy that used to cost a mere Rs 13, would now cost somewhere in the region of Rs 20 to Rs 25.

How does inflation affect me: Due to inflation the cost of every goods or service that you buy goes up. And you are not spared, whether you are spending in dollar, euro, yen or the rupee. It affects all commodities and makes them dearer every year. So in general the price of petrol/ diesel you buy at the pump goes up every year.

The amount of real return earned by keeping money in the bank goes down. For example, given the current real scenario in India, the interest rate offered in a normal savings account hovers around 3.5%. While with the recent released figures, the inflation hovers around 5% and above. If we were to assume that today you have Rs. 100 which would purchase you a cake at the Barista, then due to inflation next year the same cake would cost you Rs. 105. But since you chose to eat the cake next year, and kept the money in the bank, your money grew to only Rs. 103.5. And so you don't have enough money to purchase the cake anymore.

Are there any standard measures: In India, inflation is measured by the Wholesale Price Index (or the WPI) released by the Reserve Bank of India(or RBI) every Friday. Check under the Database -> Weekly Statistical Supplement and select "Index Numbers of Wholesale Prices". The WPI is a more broad based measure than the variably used Consumer Price Index (or CPI) used by other countries, or many other measures. The WPI numbers released for India include on the upwards of 435 item prices and give a good picture of the overall price rises.

What is the extent of the affect it has on us: Year to year, there is hardly any effect that an individual may feel. In fact with increasing efficiency in some spaces, prices may actually go down in some categories of goods, most notably technology products. But in the long run we all get hurt by inflation. Even if we assume a modest average inflation figure of 5% per year, in 20 years the cost of any good is bound to grow by 2.65 times. So we need to plan our savings in such a manner that we beat atleast that figure.

Why is there inflation: Economists vary regarding all the possible factors affecting inflation. But some of the most common reasons are

• Increase in the price of goods due to increase in demand in excess of supply available. This also gives rise to ocassional black market.
• Increase in money supply due to government/ central bank policy. Sometimes if the government sees that there is not much spending by the consumer, it may reduce interest rates to encourage the consumer to borrow and spend. This decreases the value of money, and companies increase the selling price to keep the value that they earn the same. This in turn pushes up prices.
• Higher interest rates. Due to this the cost of purchase of raw materials or labor increases for the business which may be passed onto the consumer. This effect may not be seen immediately, but is over the long term prices rise/fall to match interest rates.

Any other information: Yes. There are two more terms that be mentioned in the context. They are deflation and stagflation. Plus there are other terms like disinflation, reinflation and hyperinflation, but of lesser significance.

Subprime in a Lighter Vein

I have been reading about the subprime crisis since some time now (almost 6 months). And it has existed in the financial markets longer than that, almost a year I think. On that front I have come across lots of explanations and it takes some time to adjust to all the terminology. But occasionally I come across some posts which present it in such a manner that it makes for some easy reading.

You can find the original source of my information here. Reproducing for my benefit.

First the presentation.



And the video



Will come up with some more from what I have read.

Stock screening ideas

I have begun to heavily involve myself in stock selection. Its very interesting to learn and read financial statements, the history of a company, its current growth drivers and its competitors. Each stock has its own story to tell. And herein lies my problem. That of there being too many publicly traded companies on the stock exchange for a human to do any fruitful analysis of a stock if we select to go in any particular lexicographical order.

Apropos to this, I have been reading a bit and have learned of a few nice ideas. The foremost of the lot is proposed by Joel Greenblatt in his book titled "The Little Book That Beats The Market" http://www.magicformulainvesting.com/book.do . The strategy that the book proposes is very simple in itself. All that we need to do is look for good companies at bargain prices. And for that, all we need to do is look for companies that give a high Return on Capital Employed (ROCE) or high Return on Assets (ROA). Such companies automatically become good since they are producing better results than their competitors and have a greater sustainability to do so going ahead. And we need to get these companies at bargain. So add to it that these companies should have a high Earnings Yield or a low P/E ratio. And you are pretty much done.

All my other reading point out that this book is pretty much correct. But as Joel Greenblatt goes on to say in the last chapter, there would be a few of us (like me), who like to think that no automatic stock selection criteria is greater than our individual capacity to select good stocks in the long run. Essentially each one of us likes to belive that we are Warren Buffets all. Or the cynic in us gets the better of our logical reasoning and having read a bit more than recommended, believes that since no automatic stock selectioin criteria worked over the long term (for example the Dogs of the Dow theory), even this is not going to work. All that it boils down to is that I like to hand pick my stocks. And this above criteria comes in real handy to get me started.

Add to the above two criterias, I found some others. All common sense, no nonsense at all. I will just list them and try to rationalize them from whatever I know.

• High Return on Capital Employed (ROCE): Shows how good the managment is, since it extracts the most out of whatever resources are available to it. Return on Assets (ROA) or Return on Equity (ROE) can also be variably used. It should be fixed at a minimum of 10%.
  
• High Earnings Yield or Low Price-to-Earnings (P/E): This actually denotes how much return an individual shareholder is entitled to. I marked it to a P/E of 4. Although if you are a sophisticated investor with access to large data, you can probably go for high values of the ratio EBIDTA/EV (i.e. Earnings Before Interests, Depreciation, Taxes and Amortization / Enterprise Value )
• Low Debt / Equity ratio: Fixed at 70% and less. Any higher and there are going to be problems with the operation of the entity each time there a adverse rate move by the central banks. Although this would preclude the banking sector (which far as I know shows a high debt on its balance sheet)
• Market Capitalization: 100 crores minimum. I don't want people to run away with my money. That figure seems reasonable enough to keep the interest of other investors also piqued so that I am not the only one tracking the stock.

That's pretty much the initial screen I would apply during my stock selection. And then rank the companies on all the parameters. Those that come up higher on the list of combined rankings make the grade for my personal scrutiny and study.

That I don't fully understand the financial statements of all the sectors is a story for another day. But the above parameters at least allow me to know, which stocks I want to look at and do research on.

My credit score is being tracked !!!

I always knew that there exist credit bureaus in the developed countries which track the credit score of an individual or corporation. For example I once read some where that on the Amercian credit rating scale, a rating of less than 600 is sub-prime. I had this thing at the back of my mind since a long time, and today I just happened to come across the equivalent credit site for India.

Credit Information Bureau (India) Limited aims to (in their own words) "fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members." The Members are institutions like banks, non-banking finance companies, Credit Card companies, Housing Finance companies amongst others. It started with the joint efforts of State Bank of India (SBI) and Housing Finance Development Corporation (HDFC), Dun and Bradstreet Information Services India and Trans Union International with a shareholding pattern of 40:40:10:10, although it now diversified amongst many more entities.

The interesting thing to note is that the bureau gives out information on the basis of reciprocity. Which essentially means that institutions which have made their complete data available to CIBIL are only eligible to receive the Credit Information Report (CIR). Additionally, if your lending institution gets a credit report on you, you can obtain a copy of the report for yourself.

So the very pertinent question that remains in this day and age of identity theft and no sanctity of private personal information is one of what is the nature of information that they collect and store about us. From the website,

The CIR includes the following information:

• Basic borrower information like:
  1. Name
  2. Address
     
     In case of individuals:
     
  3. Identification numbers
  4. Passport ID
  5. Voters ID
  6. Date of birth
     
     In case of non-individuals
  7. D-U-N-S^® Number
  8. Registration Number
  9. Legal Constitution
• Records of all the credit facilities availed by the borrower
• Past payment history
• Amount overdue
• Number of inquiries made on that borrower, by different Members
• Suit-filed status.

Doesn't leave much to the imagination of the creditor, right?? Well there is an indicative list of what it does not hold also. Again, from their website:

The CIR does not contain:

• Income / Revenue details
• Amount(s) deposited with the bank
• Details of borrowers' assets
• Value of asset(s) mortgaged
• Details of investment(s)

Some relief there! And the best point there is the amount(s) deposited with bank. It would take a finance whiz to figure out all the transactions that go on amongst us bachelors/bachelorette staying with flatmates and working with colleagues.

The question that still remains whether it is good to have an entity like this. I think it is very necessary for me. I am young and earning but at the same time I am responsible. Which means my past bank balance does not determine my credit quality. When I take a loan I am confident that I will be able to repay it. With an agency like this, it does not require lengthy explanations. The finance company would ask just to make sure I still maintain the same habits.

So when are you tracked into this database. Do you use a credit card?? Did you ever take a loan from a recognized financial institution, however itsy-bitsy it was?? Did you ever overdraw your bank account?? Well if you did do any of those things, you are already in this database. You can't go off this database. Which means you need to learn to live with this. Which leaves with the one choice that one faces with every new entity. Do you want to learn more about its functioning and make it your friend for an easier financial life or would you rather suspect its intentions at the very start and keep agonizing over it and blame it for your poor credit quality.

I think I will make it my associate for a lifetime. What do you think??

Dabba Trading

Although I have not written for a while, I have been reading some. And most of the stuff that I read these days an explanation can be found on the internet, most notable them is probably the wikipedia. But I came across this new term which is intriguing and for which wikipedia doesn't have an entry yet.

"Dabba Trading" is a flourishing illegal trading in the backgrounds of the stock market. What approximately happens in such transactions is this: When a client enters a trade for say 100 shares, the broker actually registers a trade for say 1 or 10 shares with the main exchange. Then at the end of the day, the total deliverables are calculated and to hedge the positions derivatives are used. With the help of the latest available software, even the screen of the investor shows that trade for 100 shares have been registered when in reality it is different.

So the question remains why people still flock to such operators. Because these operators allow you to trade on a margin of just 10%. Because larger corporate operators have to yet reach the small towns and villages where such activity is much more. According to a recent estimate, such trades run into thousands of crores of rupees every single day. No wonder the SEBI and others are trying hard to dig these people out. The actual SEBI guideline for banning of such operations were originally issued in 2003. But they are still prevalent in India, mostly in the western parts.

Far as I could find out, a certain Pradeep Kumar Bansal was the first among the dabba traders who had been banned by SEBI on the exchanges. And that was way back in 2003. Ah! the vagaries of greed and fear that drive the fools to the slaughterhouse. As Satyjit Das, of the Traders, Guns & Money fame, would say : any form of derivative instrument is designed to profit just one entity - your broker.

For the benefit of my NRI / PIO readers and friends

Now even you can invest directly in Indian equities. Earlier there were a lot of channels. Now they seem to have reduced.

NRIs can invest in domestic markets

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Update: Changed the text into an url, since some were having problems viewing.

Revenue Recognition Methods

Depending on the business undertaking, the revenue of a firm varies according to the time and the deal with the customer. For example, a car maker gets its payment when a customer buys its car and pays for it. On the other hand, a prepaid mobile service provider gets the payment before it has provided its services - use of its network for the limited number of minutes provided. And a very visible category in the infrastructure development scenario in India is that of part payment based on the partial completion of a project, for example construction of flyovers.

The GAAP (Generally Accepted Accounting Practice) accounting standards allow for various methods for such revenue recognition. Companies are free to choose the method that best suits their business. And thereby it becomes very essential during an income statement analysis to determine that the method followed actually reflects the correct business scenario.

Sales basis method
Under this the earnings process is complete from the company, and the revenue is reasonably assured. This is the case where an individual buys a car and pays through cash or credit. Even when the customer pays through the credit card, the revenue from sale and the corresponding cost for manufacturing is recognized in the period when the sale was made. The actual cash may be delivered at any time later.

Percentage of completion method
This is the case of the airport, bridges and other long term project constructions. In these the whole work is not delivered within one accounting period. Here the revenue is reasonably assured. So at the end of every accounting period the firm recognizes revenue based on estimates of work completion. The estimate of completed work may be based on two parameters

• Actual engineering work completed as estimated by the management/ engineering team.
• Cost incurred to date, if the total cost has been reasonably estimated earlier. In case the cost estimate is revised in the future, the revised cost estimate is used to do the calculations for the next year.

For example, if it is estimated that a company A is building a flyover for Rs. 5,00,00,000 and it estimates that it would cost it Rs. 4,00,00,000. Here we assume that the payer is genuine and will pay up. Now if in the first year A incurs a cost of Rs. 1,00,00,000, going by percentage complete method, it would recognize a revenue of Rs. 1,25,00,000, thus making a profit of Rs. 25,00,000 for the first year.

If in the second year, A's project management goes on an overdrive and it incurs a cost of Rs. 1,50,00,000 for the second year for the amount of work it has done. So the total cost is now Rs. 2,50,00,000 based on which it recognizes a revenue of Rs. 3,12,50,000 [ (25/40) * Rs. 5,00,00,000 ]. The total profit for the 2 years comes to Rs. 62,50,000 out of which Rs. 25,00,000 was recognized in the first year itself. So the profit for the second year comes to Rs. 37,50,000.

Completed contract method
Under this method, the revenue is recognized only when the whole project is completed and delivery of the goods has been given to the customer. So if the project lasts for five years, there would be no profit for the first four years and would recognize it only at the end of the fifth year.

This is used when the costs can be estimated but the work is incomplete and the payment is not assured as well. Or it can be used where the costs can't be estimated by the supplier firm before delivery of the product.
Installment sales method
For example, if the cost of product is Rs. 100 and it is sold for Rs. 150. The gross profit is 50%. So when the seller receives Rs. 50 in the first installment of payment, the firm recognizes 1/3 (Rs. 50/Rs. 150) of the profit also which amounts to Rs. 50/3. This method is used when the earnings process is complete from the supplier/seller side but the payment is not assured or rests on the credibility of the buyer. For example in the current subprime housing issue.

Cost recovery method
Continuing from the above example, if the cost is Rs. 100 and it is sold for Rs. 150. When the first installment of Rs. 50 is received, no profit is recognized. With another Rs. 60 of revenue a profit of Rs. 10 is recognized. And with the remaining Rs. 40, the rest of Rs. 40 of profit is recognized in the period of the third year.
This is used when the earnings process is complete but there are contingencies built in there.

Other Comprehensive Income

Everybody knows the Accounting Equation: Assets = Liabilities + Equity.

Now the Equity portion of the equation is what the owners puts in into the business when they start a business. It also includes the money that comes into the company by issuing common stock. So if you and I were to buy shares into the company, we would also become the owners. With this overwhelming feeling also comes risk involved. The risk of losing all the money that you and I have put into our business. If our business were to fail it would take with it all our capital. So it becomes imperative to know what are the avenues where the equity increases or decreases. There are 4 such methods in which it could be affected.

Unrealized Gain/Loss on AFS Securities
AFS is available for sale securities. These are stocks of other companies that you have bought and can be readily sold in the market, but you decide not to sell them for the entire accounting period. The accounting period may be a full year, or a quarter or whatever. For example you have 100 shares of company A, valued at Rs. 100 each. So at the start of the year the value of the securities is Rs. 10,000. Although you have not done any work, yet by merely holding the securities the value of those would have increased or decreased. That essentially increases or decreases the owners' equity.

Translation Error
Suppose you were to buy 100 bottles of Château Cheval Blanc red at the start of the year for a total of 100,000 francs at the start of the year. And suppose at the end of the year it still costs the same in francs. But you would have paid in rupees or whatever currency is local to you. Now if the currency conversion rate of rupee vs. the franc at the start of the year were to be 1 franc = Rs. 35 and at the end of the year it were to change to 1 franc = Rs. 30, the change in the value of your asset would be Rs. 5,00,000. Again no transactions but you are affected by the currency rate fluctuations.

Minimum Pension Liability
Every month your company collects a percentage of your salary as your contribution towards EPF (Employees' Pension Fund) and contributes an equal amount on its own. It then invests that amount in hopes of being able to give you some interest on that money at some later date. Now depending upon its investment, there would be a deficit or gain in the amount in the fund and the promised amount it has to give out as pension to its employees. This needs to be reported in the company's balance sheet against owners' equity.

Cash Flow Hedges
Assume the case of a manufacturing company. It runs on raw materials to produce finished goods. In most cases the production planning supervisor would know the amount of raw materials the company would need, say, 6 months down the lane. Some of the materials are to be imported and paid in dollars. The company expects that the rupee-dollar exchange rate to change drastically in that time. So the company makes a deal with someone else, that for a fixed amount of rupees that person would give the company a fixed amount of dollars with which the company can pay for the raw materials. If the reporting were to happen between now and then, and supposing the exchange rate has changed, the change is to be reflected in the accounting books. Note, that the transaction has not happened as yet. But the company has committed the money at some level to the apparent profit/loss needs to be reported. In fact this is one of the ways in which TCS recently managed to give better results than expected.


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Listening to: Creed - One Last Breath
via FoxyTunes

Stock Market Wisdom

Thousands of people will give you millions of advice on how to invest in the stock market and most of them are ready to swear by the advice of Benjamin Graham, or David Dodd. Some of them go for Peter Lynch's advice. Yet hardly any of us really follow that advice. Each of these gentlemen have always cautioned against things like day trading, futures and options play. Trading in their perspective is the sure fire way to make money, but sadly it's for your brokerage house.

While I may not be qualified to say much on the subject, yet there are tips that I picked up in the last 12 months of actively following the market's trend. And the major revelation has been that it's all a game in the short term. Real wealth building comes only in the long term.

• The Sensex/Nifty are very narrow trends of just 30/50 stocks. They do not indicate the performance of the stocks that you hold in your portfolio. Always look at the stocks you own. But if you must track indices, track the broader CNX Midcap. Better still find out the market breadth, the ratio of advances (the number of stocks that rose in today's trade) vs. the declines (the number of stocks that fell).
• Whenever you buy a stock write down why you are buying it. Even if it is a tip from someone, write it down. This helps in later analysis on what kind of reasons for buying a stock works and what doesn't. Also, always keep a small note of when you want to sell it, based either on a price and/or a event. And then sell it when that happens. Emotional attachment to a stock is the surefire way to go down. Avoid it!
• I generally don't track the value of my full portfolio. That is bound to keep my heart doing high jumps. Instead I use other online portfolio trackers. Create a portfolio of the same shares that you actually own, but keep the share units down to 1 for each. This helps in showing you the percentage increase or decrease in your holding per share (not the full portfolio). Aside from hiding the absolute value of the portfolio, something which gives me the heartburn or leaps of joy, it also trains me to handle the future larger sums of money.
• If you did not beat any of the top performing diversified mutual fund by any significant margin, then it makes no sense for you to actually put in that time and effort to select individual stocks from the secondary market. Instead let your ulip or mutual fund do that for you, while you spend your time either reading up on the capital markets or with friends and family.
• If you are from an emerging market, focus on companies that geared towards reaping benefits from domestic consumption. After all, that constitutes the major definition of an emerging market - developing economy with high expectations of growth. This helps in cushioning to a certain extent on the worldwide events, although I must admit that when panic grips people they follow the herd and lose their own mind.

In the end, for the defensive investor the best bet is to follow what Graham said. A 50-50 portfolio divided between stocks and bonds. Peace of mind, nights of good sleep - things more necessary than the extra 1-2%.

For the aggressive investor, it all boils down to if you can weather the storm that might rise from time to time. After all, the question is not whether you gain or lose. Rather it is, if you are making a loss how many lessons have you learned, and when you are making a profit how much of a profit you have made.

Two cases come to my mind in this. The first one from 3 years back where accounting malpractices were reported against Global Trust Bank on a Saturday and when the markets opened on Monday, there were only sellers in the stock. It went down from Rs. 8 to Rs. 2 and later went down to 0. So a 100% percent loss to people who thought otherwise and held on to it. But there's the second case of recent accusation of cartelization against the cement industry in India. Due to this the prices of cement stocks dropped for 2 consecutive days before rising merrily beyond their previous highs.

Trashing the term insurance plans

While I have earlier reasoned why I am sticking to my Ulip plan, here I am trying to bust the myth that a combination of term insurance and mutual fund is good for an individual.

Lots and lots has been written about Unit Linked Insurance Plans (Ulips) being a bad product as compared to a combination of term insurance + mutual funds. What I tried to examine is if the term insurance products are really that good for an individual. I am not going to repeat the calculations here, since they are freely available in thousands of financial advice sites over the Internet.

You have to necessarily pay to continue with the life cover
Most pure term insurance products are based on the assumption that you will continue to pay for the whole duration of the term. Which means that if you don't pay your life cover will be terminated, albeit after a grace period in which you can revive the policy. While the same revival benefits are available, what is attractive about ULIP plans that after a certain number of years, depending on your accumulated fund you can withdraw enough to actually pay the Annual Target Premium (ATP).

Loss of capital
Pure term insurance does not give you any maturity benefits. Which means once the term is over and the life insured is still alive, they will thank their gods and won't even say a good-bye to you. They have pocketed your money, but no thanks. In case of ULIPs, after deducting the mortality charges the rest is invested, so you get back something.

Nobody buys pure term insurance
Yeah, that's true! And not because we are not educated, but because we are not financially educated and we are hell lot emotional. So when a person is faced with loss of capital, they tend to go in for money-back plans, endowment plans, etc. Such plans have a fixed term and the insurance house may declare bonuses in between or promise a lump sum amount at the end. People like such products because they want to be able to insure that their children get the education they want, or their retirement funds are guaranteed. If that is the case then why waste good money on such traditional products which promise at the max a return of 8% as opposed to the equity linked product which can potentially give a higher growth.

Taking advantage of your short-sightedness
No doubt that the way some of these insurance products are positioned are in a very bad taste. What the general public must realize that Ulips are long-term products as opposed to mutual funds. Even if you are going in for the equity linked saving schemes (ELSS), it's very easy to spend the money either because you want to buy something, or some emergency has arisen for which you need funds. But in case of Ulips, its a yearly or some such periodical payment option. Now most generally people have the insurance payment budgeted over and above the emergency funds. But how many people budget investment?? And thus it becomes very easy to spend that money that you get from the mutual fund. It is the same reason why I dislike the money back plans amongst the traditional insurance plans. And the this thing as a whole is detrimental to long term wealth building, which many of us are not able to see for us.

Read the fine-print
The pitch that any financial planner will make to you is, ULIP's are high initial cost products, almost in the range of 30%-65%. Now if you add the power of compounding to it, it represents a huge loss of income in one's lifetime. Well, those figures are wrong. Any good insurance house would have charges in the range of 40% and less and that too for the first year only. And it's not as if they sneak out that expense. It is clearly mentioned in all brochures and illustrations that they come out with.

The conspiracy
Yes, I believe that there is a conspiracy by the financial planners and mutual fund houses. In recent years the growth of the market linked insurance products have managed to attract more capital than the regular mutual fund industry. In fact this debate started when the Indian government decided to increase the limit on tax saving insurance premium payment. Earlier as per the Indian Income Tax laws, a yearly payment of Rs. 10,000 only was tax deductible under premium payment for insurance plans while it was higher at Rs. 30,000 for equity linked saving schemes. Then the Indian government went ahead and clubbed both under the same bracket and raised the combined limit to Rs. 1,00,000. Now the mutual fund industry saw red all over. Then somebody comes along and suggests, "Let's build a cartel of financial advisers who will keep trashing the ulip products and simultaneously build the reputation of the mutual fund industry." Voila! and that day onwards it has been that way.


My 2-paisa conclusion: Long term wealth building is all about controlling your emotions and getting educated in finance. It has nothing to do with which product you choose. Even the greatest of all investors and father of value investing, Benjamin Graham, suggested that you have a certain percentage of your portfolio in high grade bonds. Start early, make a plan and stick to it! That's all that is there to it.

Home - Buy or Rent??

For every educated aspiring middle class Indian home ownership is all about the attached pride that comes with it. I can just imagine having a nice little spot that I can call my own and preen when others go all gaga over small little embellishments that you have made to your living room and your own personal garden (sigh!). But then soon as we remember the phrase "middle class", realization dawns upon us and we set out to slog the hours of youth away in saving up for that all important initial down payment for the loan.

With hope in my heart I searched on the net about such discussions. I came across a very good illustration on the topic on rediff money. Here's the gist of the calculations:

• Property value (now): Rs. 25,00,000
• Rental value (now): Rs. 13,500
• Rate of inflation: 5%
• Increase in rent on a yearly basis: 5%
• Investment return: 8% (that seemed a little low!)

Additionally the author has considered property tax, and lots of small things. In the end the net outlay on rent is Rs. 46,19,303 while if a person were to buy the house it would cost him Rs. 74,29,300 over the 20 year period.

I just added a small little stuff to the above calculation. Effect of investment of the difference amount in a investment opportunity that will earn me an effective rate of return of 12% (the author assumes 8%). Also consider that the rent goes up as mentioned above, but the EMI on the house loan (calculated to Rs. 22,022) remains same. So in the first year, the monthly saving would be Rs. 8,522 (Rs. 22,022 - Rs. 13,500). In the

• 2nd year - Rs. 7827
• 3rd year - Rs. 7138 and so on...
• ... and becomes negative in the later years as the EMI stays constant but the rent keeps on increasing.
  

So compound all the positive and negative cash flows over 20, 19, 18 ... years and so on. I ran the numbers in an excel sheet and I came up with an extra Rs. 32,00,000 (approx.) at the end of the 20 years. And I think that's cool change. So the total thing adds up to the same in terms of valuation. But consider that in the rental scenario, you also have Rs. 32,00,000 as liquid cash whereas in the home buy scenario you have a home to call your own.

And that is what it all boils down to in the end. Human emotions. When you buy a home you are not effected by external factors such as increase or decrease in real-estate prices or corresponding rental. Also it serves as an important strategy in your asset allocation. Plus you tend to take care about your home and feel more comfortable with investing in whatever embellishments you want. But be aware that you need to pay for the electrical and plumbing jobs all by yourself as also property tax and lots of small things will need to be done on a regular basis, like painting it, etc.

On the other hand if it doesn't matter to you where you live, you are probably better off renting a place to stay. In case you find that the locality is not suitable to your mental makeup you can go ahead and change whenever you want. If you suddenly don't like the paint work on the walls of the apartment that you are living in, you can change. And no maintenance headache. Add to it that if you shift your job in the next 4-5 years and the property market does not rise, you are doomed to a loss considering all the taxes that need to be paid. But given the current real-estate market in India, where property and rental values have gone up 5-10 times in the last 3 years, you can make a killing of an investment.

In the end, buy a home because you are reasonably sure that you want to live in it for your lifetime. But don't buy a home because it can appreciate in value (as your broker might tell you) because you are going to live in it, and any appreciation is immaterial for you (unless you sell it and make a move). And all said and done, I will buy a house given the opportunity and when the time for such a decision arises.

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Besides the above article from rediff money, I also found an article in MSN Money. There are lots of discussions in blogs about the same.

Which Mutual Fund to buy??

Usually this question would elicit a smirk from most that I interact with, especially those that have started in their journey in the stock market and have had the beginner's luck. Not forgetting those that have made actually made quite a pile in the current bull run of the markets! But most of the these are such who are a product of the era of the market rising beyond the sky phenomena. For the more seasoned investor it is a serious consideration, especially if you belong to the category of people who don't have a job in the financial industry and also don't have much time to invest in learning the actual financial ratios and techniques for asset valuation.

While I also do belong to the fast driver category with high risk taking capacity, I needed to ponder on the question when I was asked for advice on investment avenues recently. One such was a friend of mine and another a colleague from work. And I was in a fix. While I am aware of some potential high growth stocks, when it comes to belting out the advice I am not ready to take the risk on another's behalf. So I did some research on their part and came up with a equity oriented mutual fund portfolio. This discussion does not include asset allocation strategies and risk mitigation. So I will not be taking up the case of debt oriented MFs or Exchange Traded Funds (ETFs). Also the recommendations are based on today's date and may be revised only after a year or so (essentially keep track but don't fret).

What is a equity oriented fund?
An equity oriented Mutual Fund has the objective of investing 65% of its fund portfolio in equities at the least, and rest may be invested in money market instruments or kept as cash, depending upon the objectives of the fund and the fund management capabilities of the fund manager.

First off the recommendations and then selection criteria will follow. Also given alongside is the value of Rs. 10000 invested 5 years earlier in the funds, as also the current entry loads.

1. Reliance Equity Growth Fund 113820 2.25%
2. SBI Magnum Contra 107550 2.25%
3. Sundaram Select Midcap 103170 2.25%

Criteria for selection

• Equtiy Diversified - Within equity oriented funds, there are diversified equity funds, midcap/large cap funds, sectoral funds, specialty funds and other flavors. With all the flavors except the diversified you are taking a call on a particular sector of the economy or the type of stocks that the fund would invest in. This is a very good option for those that understand macroeconomics, and those who can identify the peak and bottoms of a sector. But if you are a long term investor, it is necessary to realize that no single sector keeps growing. Almost all sectors are cyclical in the sense that they keep going up and coming down. The best example are the automobiles, cement, steel and such other sectors. So when the objective is diversified, over the long term the fund manager has the freedom to make the call on the up and coming sector.
• Age of the Fund - All three funds are more than 5 years in operations and have therefore proved their mettle. In fact they might have even undergone change in their fund managers and yet have been able to maintain their performance. Goes to show the strength of the underlying analyst team
• Assets under management - All of the above funds have more than Rs. 1000 crore under their management. This is also important, so that the fund manager has enough cash to take advantage of any opportunity arising out of market movements. For example if their is a market crash, most people would like to redeem their funds and get it in cash. But the fund manager might be able to identify good valuations of a company that he wants to buy. Large assets under management (AUM) allow the fund manager sufficient room.
• Time - I have assumed that the person investing in these funds has a long term horizon, say more than 5 years (although 3 years is also good enough) such that any sudden downturn due to sectoral calls, fund manager change or such external factors are nullified.

Mode of Investment

• Systematic Investment Plan (SIP) - If you don't have money right now but will have it regularly in the future, this is the best option. Through SIP, the law of cost averaging will help to reduce the purchase price of the units in the fund.
• Systematic Transfer Plan (STP) - If you have a lump sum amount to be invested, it is best to follow this option. In this, the initial money is kept in a liquid fund from which money is withdrawn into the primary fund at pre-defined intervals (monthly recommended). This helps in generating more than the interest rate offered by liquid savings in the bank.

After having said all this, I am sure there are people who are ready to take some sectoral calls. For such people I recommend the financial services sector, the power & energy sector and the darling of all - the real estate and infrastructure sector. For such, I can recommend (with a 3 year view)

• Reliance Diversified Power Sector fund
• JM Financial Services Fund
• UTI Infrastructure Fund

Actually there are no real real-estate funds, except those that are there with high entry barriers (minimum investments in lakhs of rupees).

Also what ever fund you select, it's necessary that you go in for the growth option. To find out the advantages of growth option over the dividend option, read this.

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Disclaimer: The risk in the recommended portfolio is borne by the investor, although if the investor is ready to share a part of the profit with me, I have no qualms in bearing the risk also.

My Life Plans and Their Financial Implications

I have come to realise that it is not humanly possible to do everything you want within one lifetime. And according to the hindu philosophy of rebirth, your incarnation in the present human form is a result of crores of births and even more good actions. So it becomes essential that you if you want to enjoy your time on this earth, you plan accordingly. Obviously there are those that would say that you don't know what would happen to you the next moment. But my point is - what if you were to survive the next moment? Would it be not better lived if you had planned on how to spend it and accordingly enjoy it. And as everybody knows, one joy leads to others, and the big cascading effect.

Leaving aside the spiritual, I am planning for the materialistic joys that I may be able to enjoy in the future. And for every materialistic joy in this world I would need money, the medium to buy everything possible on this earth and hopefully a medium which will not change in my lifetime. So in all my calculations below I will assume that the rate of inflation remains at 6%, which for the long term is a good enough assumption. I would also like to assume a min 6% increase in my income on a yearly basis, such that it keeps pace with inflation at the minimum

First the very distant future

I would like to move away from the active corporate life in the early 40's and shift into an academic pursuit of knowledge and sharing of the same. Making it more definite, at the maximum age of 45 I should be in a university and pursuing my degree in philosophy, economics or english literature. Hopefully at that age I would be happily married and have a child. So I would need to provide for them and also have enough money to be able to give up the high earning corporate life and make the transition to the life of an academic.

So going by the current market scenario, I will take a leap of faith and assume that Rs. 30,000 a month will cover all inflationary expenses for an average Indian family and allow them to live in comfort (and not luxury!). Compound it at 6% for 20 years and this becomes Rs. 96,000 per month. Round it off to Rs. 1,00,000 monthly or Rs. 12,00,000 annually. Now considering all the current monthly income schemes, it is safe to assume that a 8% p.a. income can be generated without much sweat from a decent fund. So I would need a corpus of 1.5 crore rupees to generate the desired income. Now, another another assumption is that of what would be the rate of return on my investments over the next 20 years. It has been seen that a 12% rate of return is an achievable target, even if you are a passive investor. So putting these numbers into a calculator, the magic figure that comes up is an investment of Rs. 20,000 per month in an instrument which would give me a post-tax return of 12%, which is a very achieveable figure.

In my above calcuations I have assumed only inflationary expenses, i.e. things like food, petrol, clothes, some budget for fees, medical expenses, etc. I have excluded all such items such as EMI's for car, house, and any other such things which I would hopefully procure from the extra income that I would get annually. Also I have not taken into consideration that even when teaching I would have at the least a very nominal income.

Now for some magic play with the figures above.


You can find such financial calculators all over the internet. The one from moneycontrol can be found here.

So what do I do with 6% increase in my income that I would hopefully incur. Well that goes into buying that house, the car and obviously the Harley Davidson. Again there is continued inflation even during the post corporate life. Again hopefully the income from academic activities such as teaching would augment the income to beat inflation.

Financial Dilemma

Recently I have been reading up a lot on the capital markets, personal finance and related stuff. And with this half knowledge and no experience in dealing with live cases, there is a huge dilemma that I have come into.

When I first started to work last year, I was acutely aware that insurance is a must for all middle income groups and the earlier you opt for it, the lesser premium you need to pay for it on a yearly basis. So I went looking for advice and talked to lots of insurance agents, all of whom were interested in selling me only ULIPs (Unit Linked Insurance Plans). Well at that time I took what I found to be the best plan, although all were almost the same. So I took a ULIP from Max NewYork Life.

Features of my ULIP:

• Life Invest
• Premium : Rs. 60000 p.a.
• Sum Assured : Rs. 15,30,000
• Fund Type : Growth (max 70% equity, rest in money market instruments and cash)

So far so good. But then I started reading about personal financial planning, asset allocation and related stuff and some of it has started to make sense. Wherein I landed up in comparisons between ULIP and SIP (Systematic Investment Plan) from Mutual Fund houses. And therein lies my dilemma.

Most of the subject matter dealing with comparisons between these topics advice to take a pure term plan for insurance and put the rest of the money in a Mutual Fund SIP. Essentially separate the insurance component of your financial planning from the investment component. Yet the more I think on this topic, the more I am convinced that for a person like me it is the best investment vehicle. What follows is a completely biased view on why I should continue with my current insurance-cum-investment policy.

• I tend to splurge on occasions. Which means I might at some point of time reach a level of debt wherein I find that stopping the investment option for sometime would help me recover from the debt. And that is the worst mistake that one can do when targeting long term wealth creation.
• Even the growth fund in the ULIP is relatively secure because they are completely governed by strict IRDA guidelines. Now most financial advisers would advice that out of your portfolio of stocks, some should be such that they are blue chip, or stalwarts or similar companies. So while these regulations do take care of my balanced part of my portfolio, it leaves me free to invest in high risk stocks without having to think about mitigating risk using my own judgment.
• In the future sometime I might want to go in for higher studies. Then it will be very easy to cull the investment process and use the money for expenses incurred during the non-income period. Again such a move is not recommended from the perspective of long term wealth creation.
• Different studies for the performance of the stock market over the last century have found that the annualized gain is around 15% on an average. If that is the case, then my insurance house would do good enough.
• There are other aims in my life like traveling, reading. Given a free reign with the money I can very easily divert it to such activities and not accumulate funds at all for any kind of wealth creation.
  

As I sat down to think of these above points, I also realized that there were lots of cons too with this approach. Most notably:

• For an amount of approximately Rs. 10,000 I can get a pure term insurance (an insurance plan that just gives cover and does not give any money back at any stage). So the rest of the Rs. 50,000 can be invested in a good fund which would give far superior returns. But would I put all my money in just a equities fund over the long term and would I be able to select the best performing fund year-on-year??
• The first three years after I go for the tax saving Mutual Funds, I can churn the money into the fourth year. Which leaves me a clear amount for later better investment opportunities.
  

As I was writing this post I also simultaneously watched a TV show on the annual Himalayan Odyssey organized by Royal Enfield India. Realization dawned that wealth creation is eventually about being able to align your psyche to such a goal. While I realize the need to do so, I might not be disciplined enough to keep the approach on my own. I think I will stick to my ULIP, which would enforce the investment discipline in me.

If you are reading this, and the above makes any sense to you, please do enlighten me with your inputs.

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The comments section of my blog is open again !!!

My First Financial Mistake

... or is it?? I am not yet sure, given that I don't know the rate of interest that would have been charged to me by my bank.

A couple of days back I made an online transaction to the tune of just under Rs. 35000/- The actual value had to be paid in dollars. So the most legitimate way is to pay through your credit card, which in essence would reflect on your finance statement. The other not so legal way would have been to ask a friend in the concerned country to pay for me while I remit the equal value in Indian Rupees to him through some other channel locally, probably his relatives, in India. I chose the first.

Now comes the part where I need to repay my credit card. Although my company pays me well (ok, good!), some investments and some lifestyle spends leaves me with little cash at the end of the month. Basically, I live from one month to the next month's salary. Which leads me to the situation where Rs. 35000 is a big sum to be paid in one installment, and I need a loan to repay the amount.

Besides a lot of other "attractive" facilities, my credit card allows me to convert my expenditure into Equated Monthly Installment (EMI). So if I have made a single purchase of value more than Rs. 1500 and need an extension of credit, my credit agency would gladly convert that into an EMI of 6, 12 or 24 months by charging me at the rate of 12%, a processing fee and applicable taxes. Obviously I need to call up and ask for it. Otherwise the nominal annual percentage rate (APR) is 2.95% per month (35.4% per annum), which converts to an effective annual rate (EAR) of 41.74%, which is a bit on the higher side. For the sake of convenience I opted for a 6 month payment option.

There was the other option of calling up my bank which, last heard, would have offered me a loan for the same amount at an annual rate of 11%. Here in comes the convenience part. My bank, although I have to maintain my salary account with them, requires certain documents before they advance me the amount. The actual documents required is very nominal: residence proof in some specific template, payslips, etc. etc. It would have taken me approximately a week to arrange for it all. Compared to this my credit card company does not require any extra documents since my credit worthiness is already established with them.

Now the question is how much did I pay for this convenience. For this I needed the interest rates offered to me by my bank and my credit card company. And when I actually sat down to calculate the interest that I would pay, I found I could not recall a single thing about how to go about it. Wow!!! After 25 years of formal education, I did not know how to calculate interest on a loan. And I had to sit down with pen and paper.

Take it easy. Begin with a few assumptions for both cases: (i) interest would be compounded monthly (ii) processing fee charged would be approximately same (iii) the rate of interest by the bank is 11% and the credit card company is 12% (iv) while the credit card company would extend me a 6 month loan, my bank would do it for a minimum of 12 months.

In itself calculating the amount of interest to be paid is easy, but it required some thought. First realization: one side of the equation is the monthly compounded value of the loan amount, L, after n months at an interest rate of r% p.a. (= L*[1+r/12]^n), where r is divided by 12 (to convert into monthly interest rate) and 100 (to convert into decimals from percentage form).

The other side of the equation would be value of repayments in form of EMI, E, that I would make on a monthly basis, again compounded monthly (= E*[1+r/12]^[n-1] + E*[1+r/12]^[n-2] + ... + 1 ).

Equating these two would give the value of E (EMI) to be

E = L * r * ( [1+r/12]^n ) / ( [1+r/12]^n -1 ).
While this is one way of calculating, another method is shown here. Albeit I find it a bit more round about and a bit more complex. Anyways, putting actual values into the equation reveals the following scenario.

If I take the credit card company option, I would be repaying the loan by paying an approximate EMI of Rs. 6100 (approx) for 6 months. While if I take my bank's loan option for 12 months, I will be paying an EMI of Rs. 3100 (approx). While the second option seems costlier by Rs. 600, actual calculation would not vary much from it.

But, but, but... is it the most viable option?? Here we need to consider the time value of money. Which would a full topic by itself. A simple explanation would be if I can take that Rs. 3000 extra per month from the 6 months and keep investing it and then it out after 6 months and use it to pay the rest of the installments for the 12 month option, I would be left over with something extra. But how much is the question. Will it just be enough to pay for the difference in both terms or will I have more??

Debit or Credit ??

The three simple rules of Debit and Credit:

1. Debit what comes in, Credit what goes out. (Real A/C)
   
2. Debit the receiver, Credit the giver. (Personal A/C)
   
3. Debit all expenses and loses, Credit all profits and gains. (Nominal A/C)

Real A/C : These include accounts like the cash a/c, furniture a/c, machinery a/c, etc.

Personal A/C : These include accounts for the proprietor, creditor, debtors, etc.

Nominal A/C : These include accounts for salary, interest, discounts, etc.

So far, so good. And I thought, oh that's easy. One look at point 1, and I went on to summarize that whatever is received by the account is debited, and whatever is taken out of the account is credited. I even went on to visualize a neat little cash box that a firm maintains on the part of each debtor, creditor, cash a/c, et. all. So when you put in the box, you do debit and when you take out you credit that account. And then wow! Then same visualization works for the second rule.

Just as I was thinking that this was going to be easy, up comes the third point. Whose account is it anyway?? Far as I could reason the expense/loss a/c cash box was always giving out things to others so it was always going to be in credit. But with no debit, there was little chance that the account was going to be balanced. Also need to consider that where does the money come in from. Phew! Things started going over my head.

Then somebody showed me the light of the day. My visualization while not completely wrong was misleading me. These accounts in accounting practice should not be treated as just money, as in cash. Treat them as they are, i.e. an entity called account, and they will behave fine. Waah! After all that hullabaloo about accounts being about money, about changing every possible transaction to talk in terms of money, my concepts were about to go up in smoke.

And I came across this case:

"Interest charged by creditor XYZ Co. Ltd. Rs. 2000"

Hitting the roof was never easier earlier to this. How much ever way I tried to apply the three rules, or any combination thereof there was simply no way I could balance this. My explanation: Rs. 2000 paid as interest. So considering that there is an interest expense a/c I debited the account by the same amount according to rule three. Now I took a look at XYZ Co. and applying rule 2, I debited their a/c. Now wait! How is this going to be balanced?? When an a/c is debited another is to be credited, right?? But here both are being debited. That angel came to rescue with an explanation. You always treat the creditor (the debtor for that matter) as a liability. So when the creditor pays you money (which you are supposed to pay back), according to rule 2, the creditor goes into credit. Similarly, the interest that you are paying your creditor is a liability. It is a sum of money that you are supposed to pay your creditor, although the creditor has never actually paid you the amount. So, to show that the you owe such an additional sum to the creditor, you need to credit the creditor a/c with the additional amount to balance your books.

These concepts are supposed to be grasped by a student in the 11th grade studying in India. I started to wonder at that social notion that the Indian society attaches to a student taking up commerce/ accounts papers. It's as if they are the lower of the student fraternity. All bright students are supposed to take up science and become doctors or engineers. Far as I am concerned, this simple thing was no less than "Rocket Science". (been long since I used that phrase; the last time I remember having that feeling was when I read "Analysis of Mind" by Bertrand Russell)


I am just beginning to learn such concepts in finance. I maybe wrong or right. If you are reading it, keep that pinch of salt with you (Don't forget the lemon and the shot!)

Update: Found this site with an explanation of the Accounting Equation, which is what I have been talking about above. Good examples.

How Much Dividend Did You Get??

110% dividend, SBI MAGNUM TAX SAVING FUND. Last date 02.03.2007. Invest Rs. 11000 & take back Rs. 5500 immediately.

This was the text message sent to me by a friend of mine, who has been investing in the capital markets since over a year. I called him to verify that he knew what he was talking about. As happens with most of us, we just talk to some finance agent and take his advice without proper research as to what all that finance jargon means. As a matter of fact the more industrious of us put some effort into selecting a fund house but hardly any research as to which option within the fund to take. In this post I will try to answer the most basic questions about mutual funds that I had when I was new to investing.

Dividend payout is not some extra money.

Let's say a fund has a Net Asset Value (NAV) of Rs. 100 and it declares a dividend of 25%. You as the investor get Rs. 25 for every unit of the fund that you own. But what happens to the NAV. The NAV for the fund now reduces by 25%, i.e. it becomes Rs. 75 (Rs. 100 - Rs.25). In essence you have not made any profit. Rather, the fund management capabilities of the fund manager is in question. Why do you ask?? Because there is no fixed dividend declaration date for any fund. It is upon the whim of the fund manager that a dividend is paid to you, and one of the reasons why a fund manager may do that is because s/he could not see any viable investment opportunities.

Change the whim of your fund manager into your fancy.

When the fund gives out dividend, the NAV of the fund falls but the total number of units you own remains the same. Adding up the dividend payout and the current value of your investment, i.e. (NAV x no. of units), the value of your money remains the same. Now considering the current tax scenario in India, there is no capital gains tax for income incurred after a year. So how do you leverage this?? Simple. Sell some of units that you own in the fund. While the NAV of the fund remains the same, the number of units fall down. But you have the money you got by selling part of the fund with you. So it is upon your fancy that you get money out of the fund.

Where else am I losing money??

I loose money every time I invest in a dividend paying fund. Because most of the times such a fund will make a big effort through advertisements to preen about the amount of dividend that is being paid. And such extra costs will be added to the fund management costs, which eventually will lower the earnings. While in the growth option, at least such extraneous costs will be saved.

Any other avenues where it can be saved??

Yes. The full scenario is big and out of scope of this blog. But something that can be understood easily is this. When a fund pays out dividend, it is most likely to lie in my bank account for some period of time before I can re-invest it again. During such period not only I loose the earnings that might have incurred, I also need to pay the entry load, which in the current market scenario is anywhere between 2.25% - 2.5%. I think the picture is clear.

Surprises galore!!!

Ok. So two fund houses come out with competing NFO's (New Fund Offering) with approximately the same investment objective. So what's the deciding criteria for selection?? The NAV!!! Wrong. From a biased perspective, it would be the size of the fund house and the performance of other funds being handled by the fund manager. Why not the NAV?? Because if the fund were to buy just shares of some company say X which is currently priced at say Y rupees, then it will have to shell out the same amount of money irrespective of what its NAV is. So while the fund with lesser NAV will use a larger number of your units to buy the shares, the fund will higher NAV will use a smaller number of your units to buy the shares.

Sources (and more detailed explanations):

Don't fall for the dividend bait!
Growth or Dividend - How to make the right choice?
Demystifying NAV myths
Dividend Reinvestment v/s Growth - Let your taxes decide

As for me particularly, I wish I could save some money to actually invest. I console myself that I earn more intangible assets than tangible assets.

By the way, this post is highly biased towards investing through the growth option or at least the dividend reinvestment option. For a more convincingly biased approach, you must read the above mentioned sources. Happy investing!!!

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Correction: Thanks to Gautam Satpathy for pointing out an error in the above post.

The dividend percent that is declared is on the face value of the fund unit, not on the prevailing NAV. So if the fund was issued at Rs. 10 per unit, but currently is at Rs. 80, 25% dividend would be Rs 2.5 and not Rs. 20. Correspondingly, the fund value would drop by Rs. 2.5 to Rs. 77.5 and not by Rs. 20 to Rs. 60.

There are others he has mentioned but I will get to them once I have investigated them.