Economy

Pick the right investments

You must be clear about what you want out of the investment and about the product itself

You invest your hard-earned money in various combinations of equity and fixed income options, either directly in stocks or bonds or through a vehicle such as a mutual fund (MF).

If you are not from a finance / investment background, the investment product may be mis-sold to you. How do you protect yourself?

First, be clear on why you are investing i.e. what your investment objective is. It may be for retirement, for purchase of an asset such as a house, or simply saving and parking your surplus for a rainy day. How is this relevant? It gives you an idea about how long you can spare that money.

If it is for retirement, then you can do without it for a long period of time. If it is for emergency requirements, then it would be required at short notice. How is that relevant?

Investment horizon

The longer your investment horizon, the ups and downs in the interim period are less relevant. The other aspect is liquidity. If it may be required at short notice, it should be parked somewhere, from where it can be withdrawn easily.

There should also not be much of impact cost on selling. The equity market is liquid but if the market is down when you need to sell, you would realise less than the potential. A bank deposit or a liquid MF would not have an impact cost.

You have to figure out one more thing. For your long-term investments, how much of market-related loss can you bear without losing sleep. If you are not comfortable with the ups and downs in the market, then opt for something less volatile e.g. fixed income. In other words, equity being relatively more volatile, have as much equity as suits you.

If you are not concerned with every-day ups and downs, you may have a higher extent of equity investments in your portfolio. To be noted, market-related loss is not real loss till you sell the investment at the lower price. As long as the fundamental quality of the company / industry is intact, the share price would typically recover over a long period of time.

Now, let’s discuss what we set out to. There are multiple types of investment products, ranging from plain and simple bank or post office deposits to various types of MF schemes to buying equity shares from the market.

There are insurance products, both endowment and unit linked, that combine investment with insurance. Then there are products that are safe from default risk e.g. RBI Savings Bonds or Sovereign Gold Bonds that are not so liquid. That is, if you require money prior to maturity, you may not get it. On what basis would you decide where to invest and how much?

In the banking industry, there is the concept of SLR, which stands for statutory liquidity ratio. For investments, one may assign a different meaning to SLR, setting the order of priority: S stands for safety, L for liquidity and R for returns. As you can see from the order, safety comes first and return comes after the first two.

To understand the safety aspect while buying a financial product, you have to gauge the risk first.

There are many types of risks; the two major ones are volatility — ie market price coming down suddenly — and default risk.

We discussed volatility risk in equity investments a little earlier. There is no default risk in equity. In debt or fixed income investments, there is volatility risk, though lesser than in equity, as also default risk as there is a committed payment from the issuer of the instrument.

In fixed income, bank deposits have an insurance cover of up to ₹5 lakh per bank but even beyond, banks — particularly the government-owned ones — are safe because of their overall importance in the financial system. Fixed income investments such as post office deposits, RBI Savings Bonds or Sovereign Gold Bonds do not have any default risk, by virtue of government involvement. Private sector corporate bonds do have default risk.

Now, you have to understand these aspects when you are about to put in your money. You may do so by taking the inputs from the entity / person selling you the financial product, or conduct your own research. To summarise, you have to gauge:

Volatility: i.e. how much can the market decline (e.g. 10% or 30%), going by historical track record of the investment.

Default risk: if it is not among the safe options mentioned above, what are the incidences of default historically in that investment.

Liquidity: if you require money at short notice, is the asset available i.e. is it possible to sell quickly. Real estate is less liquid, while financial assets are more liquid. Even in financial investments, go through the terms for exit.

Taxation: though not as important as the first three, it is relevant and you should have a perspective on that.

In short, you must have clarity on how an investment is suitable for you. It is not about the “attractive” returns, but about why you should get into it.

(The author is founder, wiseinvestor.in)

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Printable version | Jul 16, 2020 7:41:07 PM | https://www.thehindu.com/business/Economy/pick-the-right-investments/article31660373.ece

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