India Sensex hurting !

Sensex pundits now talk of structural problems, given the dive in the Indian stock market. This was the same bunch talking the Sensex to further highs past 20,000. If you had invested in the index at 20,000, you would be poorer by 7.86% in a very short period of time !

Experts and market analysts are taken aback by today's industrial production growth figures that puts Sept 2007 growth at 6%+ down from 12%+ same time last year. Increasing loan rates, squeezed credibility and higher rupee seem to be weighing heavily on growth indicators - effects of these actions should not be a surprise to anyone!

Sensex is most likely up for a period of volatility. You need to maintain a longer term value-driven view to have the stomach to take this churn. Its like buying a house - you don't check prices every day and don't look to sell quickly. When you buy shares, you are effectively buying ownership into the company - a commitment that is best given some time to bear fruit. If you have selected the company right and bought at appropriate price/value, you could be in for sustainable value creation.

Insurance (car, home) in India to become cheaper

Insurance in India is set to become more price competitive, thereby taking less out of your financial planning budget.

IRDA, the insurance regulator had freed the pricing regime for general insurance products (car, home, fire etc) on 1 Jan 2007. This led to massive discounts by insurance firms. The regulator then stepped in and capped discounts at 51%.

Cap is being removed wef 15 November 2007, which should see massive price competition reducing premiums steeply. Competition is good !

Savings in India: proposed changes to Provident Fund (PF)

If the draft guidelines issued by the government last month take effect, private provident funds will have more flexibility in how they can invest the funds at their disposal.

A summary of the key changes proposed in the guidelines:

• Amount that may be invested in shares of companies listed on the BSE or NSE (subject to being rated “investment grade” by at least one agency) or in Equity Linked Savings Schemes of mutual funds to go up to 10% of total funds, from 5% previously
• 25% of total funds may be invested in deposits of private sector Banks that fulfil capital adequacy and net worth criteria
• Trustees are allowed to decide if a further 30% is to be invested in money market funds, bank deposits or public sector bonds
• Requirement of investment in Central and State Government securities or mutual funds where the underlying assets are such securities, to be reduced.

Should these guidelines be passed, this retirement planning option could yield higher returns. While this is a welcome development, people must realise that the primary objective of a provident fund is to provide sustenance during retirement. Unfortunately, a lot of people withdraw these funds to meet large or unexpected expenses. By doing so, they forgo several benefits:

• When the provident fund in someone’s account completes 5 years (with a single employer or otherwise), the withdrawal becomes tax free. In contrast, early withdrawal requires that the employee pay tax on his or her entire contribution
• The Employee Provident Fund pays a tax free interest of 8.5%, which is attractive compared to many other instruments
• Once can still meet exigencies while not liquidating the corpus since there is a provision that allows the account holder to withdraw funds under specific circumstances, such as medical emergencies or construction of a home.

The provident fund is intended for retirement. As far as possible, it must be protected for this use.

Risk appetite for individual investors in India

Exuberance in stock markets (Sensex), of the type seen recently in India, often leads to individual investors behaving in one of two ways:

• Investing with the herd
• Never finding the right level to enter the market !

Both these outcomes have the potential to be painful for individual investors. When you invest with the herd, you are never really sure if you are picking ‘yesterday’s’ good news and therefore buying at close to peak. On the other hand, if you stay out of a rising market for too long, you are likely to miss out on significant gains. What should an investor do in such a case ?

It comes back to thinking of investment as a long term game and building a diversified asset portfolio that meets your risk appetite as you go through different life stages.

A popular yardstick to understand one’s risk appetite for equities is to measure it as ‘100 – your age’. For example, if you are 40, this yardstick suggests that you can have approximately 60% of your asset allocation in equities. In our opinion this yardstick need not be correct for many investors. Risk appetite is a personal matter and it can vary based on an individual’s situation and age.

Some believe that it is better to have an investment strategy built around how much you are willing to lose as opposed to how much you would ideally like to make. Risk appetite could then be defined as how much of value you would be ready to lose over short /medium term (up to 3 years). If the answer is 40 to 50%, then you obviously have a high risk appetite and are investing for the longer term (e.g. 10 years). In such a case, a relatively higher proportion of riskier assets that can outrun inflation by a significant amount could make sense. Investments in stocks, particularly in emerging technologies, mid caps, etc could give you the upside in such situations.

However, if you are willing to lose no more than say 10 to 15% of your investments’ value over the short/medium term, then you can be classified as a risk averse investor who could be better off with more ‘secure’ investments like bank deposits, etc.

If you have the heart to lose between 15 to 40% of your investment value over the short/medium term, you could be classified as a moderate risk investor. In such cases, your portfolio could contain balanced mutual funds that diversify your risks and have about 65% of their assets in equity, the rest being in ‘safer’ instruments.

Please recognise that the investment percentages talked about above are primarily for liquid assets – i.e. do not include property which typically forms a large portion of many investors’ portfolios. Also, the risk appetite percentages of 10-15%, 15-40% and 40-50% are indicative.

We will talk about what a typical portfolio might look like for these three investor classes in a subsequent article.

Calculating your Net Worth

So you think, you are well on your way to building wealth. Let us do a test to measure your current Net Worth:

1. Start with current market value of your major physical assets: house you are living in (if owned) + investment properties + bullion/jewelry. etc.

2. Add current market value of liquid and movable assets: mutual funds, stocks, bonds, bank accounts, derivatives, deposits, retirement accounts (PF), automobile(s), consumer durables (s) etc. Please note that automobiles and consumer durables would have depreciated in value and therefore use a reasonably accurate value of their market value

3. Add payout value (including target bonus) of endowment/investment type insurance policies. Ideally, you should use present value of the proposed payouts - however, if you cannot do this, use the payout value as an approximation. This approximation could overstate the current value of such instruments.

The total is your assets.

Now deduct the following liabilities:

4. Value of outstanding loans taken to buy properties + automobile(s) + consumer durables

5. Value of balance on credit cards + student loans + marriage loans + other loans/commitments

The net result is your current Net Worth. Does the picture still look pretty ?

Typically, one is financially stretched during the family building stage (30 - 50 years) after which a rapid rise in Net Worth is required for comfortable retirement. Please remember that people are retiring earlier and living longer !

Can retirement hurt less ?

Retirement is a financial challenge for most. What one saves through working life can seem less than adequate for the 'peaceful' years of retirement. Increasing life spans make it critical for people to plan for 25 + years of retirement, inflation continues to erode savings and interest rates continue to moderate as the Indian economy matures. What should you do if you are intent on having a pleasant retirement ?

1. Set your target: It is important to know what amount of money, in today's terms, you would need at your retirement. For example, if you are 35 years of age and think that Rs 25,000 per month (in today's terms) is a good sum for retirement, plan to retire at 65 and hope to live till 80, then you can expect to require close to Rs 1,10,000 every month in the 66th year. This is simply because inflation continues to lower the purchasing power of your money. To get to this number, you should plan to have savings of approximately Rs 2 crores by the time you retire. If you want to maintain your lifestyle, this pool needs to be closer to Rs 4 crores in your 80th year !

2. Start young: Only way to do this is to start young ! A typical rule of thumb is to save up to 30% of your gross salary through your working life. Compound interest helps the savings pool grow in a healthy way even as your earning and savings power increase over the course of your career.

3. Create a portfolio: Build a balanced portfolio throughout your life. It should have a good mix of real estate, stocks, mutual funds, bonds, deposits and possibly gold. The riskier assets like stocks and and equity based mutual funds could form larger portion of your portfolio when you are younger (say 70%) and move to a more stable portfolio as you arrive into your 50s (deposits, real estate and bonds forming most of your portfolio). Many people forget to create a portfolio and put all their eggs in one basket - typically real estate !

4. Leverage early: Another way to create wealth over the longer term is to take loans wisely. Home loans are an important instrument that one could use from fairly early in life. It has been observed in most developed countries that people build property assets by taking loans and upgrading throughout their life. Home loans also offer tax advantage. While home loans can be useful, excessive debt on credit cards, personal loans or margin lending (against stocks) can be dangerous - use such debt only with care !

5. Manage your portfolio: It is normally wise to take profits along the course of your investment period and reinvest into the lows. While very few can time markets, it is important for investors to remain flexible in terms of liquidating assets, booking profits and waiting to pick new assets at the lower end of price cycles. Being brave is key, especially in turbulent economic times !

6. Plan tax wisely: It is important to plan taxes well. There are approved tax breaks like the ones on home loans and 80c that should be considered carefully.In closing, it must be highlighted that the above ideas are just pointers. It is important that you seek advice on your finances and taxes from professionals early on. Should you find good ones, there may be a chance of getting to the number !!