When you first start out to plan your finances, it is likely that you are overwhelmed with the options there are. There are a number of instruments that will help you grow your money, but how do you choose which ones are appropriate for your needs? We’ll give you a brief on the popular investment avenues and tips on how you can make your decision.
To understand this, the following will help you put investments in perspective. Investments are all split into “asset classes” – primarily these are equity, debt, gold, and real estate.
Equity refers to the stock markets. Debt refers to an investment that is linked to fixed returns for a particular maturity period.
Now, on to the main investment product options available and what they are:
Public Provident Fund (PPF) comes with a fixed interest rate for each year, which is pegged to prevailing government bond yields. With an upper limit of Rs.1,50,000 per year, it is meant to inculcate small saving habits. The investment amount is locked-in for 15 years and is eligible for tax saving deduction under 80C. Current rate of interest on PPF is 8% per annum. EPF is similar to PPF.
The positives: With a long lock-in period, PPF ensures that you put aside some money for the long term. Apart from being eligible for tax deductions, the interest on PPF is also tax-free.
The negatives: Being a debt product, its returns are limited and even investing the maximum amount each year may not be enough for your retirement corpus.
- Fixed Deposits
FDs issued by banks are more common, but corporates issue FDs as well and often with higher interest rates. FDs have fixed maturity and can range from 7 days to even 10 years. A few bank FDs have become more flexible with premature exit options but largely they are locked in for the maturity period. Prevailing interest rates in popular banks is around 6.5%-7% per annum while the higher risk counterpart corporate deposits offer around 8.5%-9%.
The positives: FDs are low-risk, offering a guaranteed return. Setting up recurring deposits and using your bank’s sweep facilities are a great way to build up investments. FDs ensure that your money is not idling in savings account earning minimal interest.
The negatives: For longer time periods, FDs aren’t great. Historically, they haven’t given inflation beating returns. Interest income is also taxed at your tax slab. Depending on FDs alone for all your needs means you need to save up a high sum or you may miss your target.
Insurance in its true sense is a risk cover. But some life insurance policies like endowment and money-back policies place themselves as investments. This is because they offer some benefits on maturity even on survival. ULIP is a hybrid product where a part of the amount gets invested and a part goes for the insurance cover. ULIPs have different schemes which invests in equity and debt market.
The positives: Insurance provides a protection. Premium payments qualify for tax deductions.
The negatives: They are not investments. Variants which give lumpsum amounts at the time of maturity may look attractive, but the returns are poor given the time you stayed invested. ULIPs give you a life cover and returns from your investment. Unfortunately, the life cover you get for the premium paid is minimal, when compared to plain term insurance. In a ULIP, you get neither adequate insurance nor investment. Liquidity, transparency, and comparisons of ULIPs are also poor.
- National Pension Scheme (NPS)
NPS is a pension scheme which invests in a combination of equity, corporate bonds and government securities. You can decide the allocation between each yourself, or you can allow the system to choose it for you. The scheme matures when you turn 60. At that time, up to 60% of the amount can be withdrawn and the rest is compulsorily invested in annuity. Early exit option is available after 10 years from the time of account opening but 80% is converted into annuity. Even though premature withdrawal is possible for a certain amount, it comes with a lot of rigid clauses.
The positives: NPS gives an additional tax deduction of Rs.50,000 under 80CCD. Similar to PPF, the long lock-in period ensures that there is a retirement fund is in place. The addition of equity helps improve returns compared to PPF or EPF.
The negatives: For disciplined investors who don’t need such constraints, NPS is a bit too rigid. Compulsory conversion of a large portion of the end corpus into an annuity is not tax efficient nor attractive in terms of returns.
Gold has traditionally been used as a savings avenue. But physical gold is not an investment because of challenges arising in purity, storage costs, wastage costs, and liquidity. Financial gold is more effective in capturing movement in gold prices without having to deal with physical gold. These include Gold ETF and gold mutual funds. Gold sovereign bonds issued by the government are also another way of investing in gold, and comes additionally with a small interest component and taxation benefits.
The positives: Its low correlation with stock prices and its counter to inflation makes it a good hedge against market risk.
The negatives: Gold as an investment does little to your overall portfolio. Their prices move solely based on global equity market sentiments and the exchange rate. Gold prices can and have stayed stagnant for long periods of times.
By investing in shares (equity) of a company, you become a shareholder. The returns you reap will come from the growth of the company which will reflect in the price of the stock. There is no cap to these returns and stock prices can rise multi-fold. A small amount, therefore, can grow in very large sums. You need a trading and demat account to transact in stocks.
The positives: Equity has historically been the highest returning asset class. Higher returns mean you can invest lower amounts – so a large corpus target can be achievable even if your savings capacity is lower.
The negatives: Picking stocks comes with high risk. It requires market expertise. Stocks can be very volatile and therefore require both risk appetite to stomach rapid change in values as well as conviction to hold on to the stock. While volatility evens out over the long term, it still needs time. It can be safely said that equity investing is not for all and you should refrain from investing directly in stocks if you don’t understand the equity market well.
- Mutual funds
A mutual fund is a pooled investment vehicle which invests in equity, debt, or gold and is managed by investment professionals. Choice of investments and their management is made by fund managers. Mutual funds charge a fee for such management. Eventual returns will be decided by which asset class you invested in. Broadly, returns from equity mutual funds will be market linked whereas debt oriented mutual funds will be a notch or two higher than that of fixed deposits.
The positives: Mutual funds give you professional management of both equity and debt markets without you having to make choices yourself. The variety of mutual funds means that you can find a fund that matches all your requirements. Open-ended funds can be exited anytime, giving you flexibility to structure your investments around your needs. Debt mutual funds have lower taxes than bank or corporate FDs.
The negatives: The same flexibility can turn harmful if not used prudently. Easy-exit and no lock-in feature of mutual funds can hamper long term wealth building if not used for the right purpose. You will also need to track your mutual funds from time to time to ensure that they continue to be good performers.
What you should consider
Now that you understood features of different products, you need to see which ones suit you. For that, you need to consider two important things – your needs and your risk appetite.
First, let’s understand what risk here means. It is the uncertainty in returns and probability of losses. For example, returns from any equity product is volatile and cannot be predicted beforehand. Whereas debt-oriented products, like PPF and fixed deposits, are more predictable and low risk. The more you’re able to withstand volatility in returns and losses, the more risk you can take and vice versa. But why should you take higher risk? The trade-off here is higher returns. So, while equity (stocks and equity mutual funds) is risky, returns over time compensate for this. While debt (FDs, PPF, debt mutual funds) is low-risk, so are its returns.
Second, your needs. You can think of your needs as the purpose for which you need money. Split this into what you would need in the short term versus money that you can put away for your future. To keep it simple, call anything longer than 7 years as long term. If you don’t have a well-defined goal and you just want to save up your surplus, consider it to be long-term as you have no definite use for it.
How to make the choice
Two simple rules. One – longer the timeframe, higher the risk you can take and vice versa. Two – the more risk you can take, the more equity investments you can make and vice versa.
Here are a few pointers. For short term needs and contingency (emergency) funds, you’d need a stable source of returns, easy conversion into money, and low risk. You can consider bank FDs or debt mutual funds for that purpose. PPF is unsuitable because of its long lock-in. Don’t use equity-oriented products for short-term goals, no matter how attractive the 1-year or 3-year returns may look.
For long term wealth building or a timeframe of 5 years and longer, include equity as it delivers superior return and you can build more wealth. Be it through NPS or mutual funds or direct stocks, up your equity exposure longer the time frame and the more comfortable with the market. You can include an exposure of 60%-80% in equity for a period more than 5 years, depending on your risk level. Put the remaining in debt-oriented products like FDs or debt funds. Don’t put all your investments into equity – that’s just exposing your entire portfolio to high risk with no means to limit volatility.
Insurance products for the purpose of investment can be written off the list. Simply hold adequate term insurance (thumb rule is your sum assured should be 10 times your annual income) and medical insurance.
If you get confused by the array of products out there and whether you should invest in those, just do this – look at how it gets its returns, the risk level it involves, how long you can give that investment the time to perform, and how easily to can liquidate it either to meet your needs or if it is not performing well. Then blend these products to create a portfolio that suits different aspects of your needs.