Many a time people ask: “Tell me a good mutual fund?” This question is similar to asking a doctor: “Give me a good medicine?” How can the doctor suggest anything without knowing the problem?
Though the question is wrong, immoral sales people take advantage of the gullibility and lack of knowledge of the person raising the question to sell their products. They cannot be taken to task as well, since they have in one way given the right answer. The problem is that the question is wrong.
Major investment decisions have been proven to be wrong, leading to financial goals not being achieved by great margins. Imagine a father investing for his son’s engineering education for 18 years and falling short by 75 per cent – where he needed Rs. 4 lakh, he got Rs. 1 lakh. The problem was with a mix-up with respect to the asset class. He was sold a pure debt investment when an equity-based fund would have served him better.
1. The questions
This article will cover most of the relevant methods to compare investments. The idea is to arm ourselves with the right questions so that we can get the right answers to achieve our financial goals.
The comparators used for financial investment tools analysis are not the same for all tools. So we will in this article see all the comparators and how they are suitable for different tools.
2. The returns
Is the financial instrument/tool/investment that gives the highest return the best one? No, not necessarily.
This is due to the fact that the return has different components and their values depend on a number of other factors too.
There are two components to returns: current income and capital appreciation. Current income is the regular cash flow that we get from the investment. These are like interest from a bank deposit, dividend from a company or mutual fund, rent from a house or commercial building. This cash coming to us can be regular and a known quantity like a bank deposit and rent. In case of dividends the quantum of incoming cash and time when it will be paid out is not always known in advance.
Current income may be more important to some people than others. A regular known income is more needed for a pensioner than a fresher.
In most cases (except real estate, shares and some mutual funds) the investment itself will not grow in its value when there is a current income. A bank deposit of Rs. 10 lakh remains the same at the end of the term. Even in case of a cumulative deposit, the face value of the deposit is the same Rs. 10 lakh, the interest is the rest.
Current income is always taxed, either in our hands (in the case of interest) or in the hands of the person paying it (in the case of dividend).
3. Capital appreciation
This is the growth in the value of the investment itself. The land that we had bought appreciates in its value itself. So does the share and the mutual fund bought with the “growth option”.
As with the current income, capital appreciation is preferred by some more than the others. A young person would want more of capital appreciation than a person nearing retirement. The issue with any investment that can give capital appreciation is that there can also be capital depreciation – reduction in value of the investment. So anyone with a firm short-term commitment should look to preserve the capital than look for appreciation.
Risk is the deviation of actual returns from the expectation. So in one way the risk that we face from any investment depends on us (we are the ones who have the expectations). One of the measures of risk for an investment is its variation in returns from time to time (volatility). If the variation is high, the investment is said to be risky.
That way a bank deposit though giving lesser returns is less risky as it has lesser variation in returns. However, the risk with bank deposits is the interest rate risk. This is so because after I made my investment for five years, the bank may increase the interest rate. Or the interest rate today is lower, so I am not able to reinvest gainfully.
The other risk is with the slowness of growth itself. What if the capital is preserved, but the growth is lesser then inflation. Here again we are losing the value on money. So there is no instrument that can be called risk-free. We need to choose an instrument based on our time frame and our ability to take the risk.
This is the speed at which an investment could be converted cash quickly. Gold has the highest liquidity as it can quickly be pledged for cash. Selling gold though may not be as easy. Shares have the next highest liquidity (two days to cash in bank). Mutual funds come next (one to three days for liquid or equity funds).
Real estate has the least liquidity among investments.
6. Tax treatment
A very important aspect to be considered when investing is the tax treatment. Some investments today in India still enjoy Exempt-Exempt-Exempt. This is basically getting favorable tax treatment at the time of investment, at the time there is income and also at the time of maturity. We are moving towards the Exempt-Exempt-Tax regime where investment maturity proceeds will be taxed. The first to come under the EET regime is our pension funds.
This is the final measure for comparing investment. Convenience is a broad heading under which the ease of understanding the investment, ease for investment in quantum of money, frequency of payments, specialist support to manage the investment, ease of maintenance, etc, come up.
A mutual fund has very high convenience factor because investments can be as low as Rs.500 per month (even lower in some cases), has professionals who manage it, gives the advantage of diversification, can be redeemed very easily (except those with lock-in period). Real estate has the least convenience as it requires huge investments, and in India has to be managed by ourselves (only very recently do we have some professional support to manage real estate).