Making efficient utilization of the Capital earned (India)

Dear Friend:

Warm Greetings!! As rightly said: “Ignorance is bliss and so is supreme knowledge; it’s the transience that causes all worries”. As I gallop towards quenching my thirst for supreme knowledge in the domain of finance, I am taking this opportunity to pass on my knowledge (on an as-on basis) to clear the ignorance of my peers and friends and their friends (make them more worried about their personal financesJ , till they too strive to reach the state of supreme knowledge). I have a belief that this would turn out to be a mutually beneficial exercise, biased towards my side.

OK, enough talk. Now let’s try and understand how we can make an efficient utilization of the capital we earn. Other than having an efficient personal expenditure pattern, we can also

·         Prevent unnecessary outflow of capital (Tax savings)

·         Put our capital at work (investments) “intelligently” for increasing future capital inflow

Handing over money to the taxman is hardly the most pleasant of tasks and feelings. However, many of us pay more tax than necessary, mainly because of a combination of ignorance and laziness. Moreover, we do not assess the risk/return profile of the investment instrument we choose and many a times end up losing capital there too. Hence, lets first shortlist for ourselves, what are the various instruments we have.

Remember: Each instrument (even though under same heading) is different and should be chosen based upon individual requirement only after proper investigation or consultation.

Instruments for Tax savings

1. Public Provident Fund (PPF) (U/s 80C)
2. ULIPs/Life Insurance (U/s 80C)
3. Tax saving Mutual Funds (ELSS) (U/s 80C)
4. Home Loan (U/s 80C and 24B both)
5. NSC (U/s 80C)
6. Post Office Time Deposit (U/s 80C)

Asset Classes for Investments

1. Fixed Income Instruments (Debt Instruments)
2. Equity Instruments
3. Alternative Instruments

Characteristics of these asset classes:

1. Fixed Income/ Debt Instruments: Returns moderate around 8-10% per annum. Deviation of returns (risk) is zero. Hence the name.
2. Equity Instruments: Returns very high approx 30-40% (during bull market) and very low minus 25- minus 35% approx (during bear phase of the market). Deviation of returns (risk) is very high.
3. Alternative Instruments: Sophisticated instruments requiring specialized knowledge.

Fixed Income Instruments

1. Fixed Deposits (FDs)
2. Bonds
3. Kisan Vikas Patra
4. National Savings Certificate (NSC)
5. Public Provident Fund (PPF)
6. Debt Mutual Funds
7. Fixed Maturity Plan (FMPs)
8. Money Back Endowment Insurance Policy

Equity Instruments

1. Stocks
2. IPO Investment (First day selling)
3. Futures, Forwards, Options (Derivatives)
4. Equity Mutual Funds (Diversified, Sector, Index, Market cap oriented, Quant, fund of MF)
5. Exchange Traded Funds (ETFs)
6. Unit Linked Insurance Plans (ULIPs)

Alternative Instruments

1. Investment Commodities
2. Consumption Commodities
3. Real Estate
4. Hedge Funds / Fund of Hedge Funds
5. Private Equities
6. Film Funds, etc

Now, let’s analyze a situation; a layman (say Rakesh) wishes to save income tax and simultaneously increase his wealth. What are the instruments available with him? Following:

• Public Provident Fund (PPF) (U/s 80C & Debt Instrument)
• ULIPs/Life Insurance (U/s 80C & both Debt and Equity Instrument or combination)
• Tax saving Mutual Funds (ELSS) (U/s 80C & Equity Instruments)
• NSC (U/s 80C & Debt Instrument)

Although all of will give him similar tax benefit (U/s 80C), however when it comes to wealth creation these instruments will behave accordingly to whether they are Debt Instruments or Equity Instruments. But here lies the million dollar dilemma; if he invests in a debt instrument, he will miss out on the exponential capital appreciation prevalent during bull market whereas if he invests in an equity instrument, he runs the chances of losing a lot of his capital during a bear market. So what should he do?  Some of his well-wishers may suggest him to have two investments, in either instrument. However, if we crunch the numbers for future returns we will find that there is a more efficient approach. So what is this efficient approach?

“Put your money in an instrument which invests in equity during bull market and automatically realigns itself as a fixed income instrument if the volatility of the market increases/market enters a bearish phase.” Hence, Rakesh, who went ahead with this innovative instrument, got the double benefit of exponential capital appreciation during bull market and downside capital protection during bear market within a single instrument. A clever choice I must admit.

So, if you stay any where in India or abroad and wish to know more about this instrument or any other instruments mentioned above, do contact me:

Either, drop a mail to mabhik@gmail.com  (preferable)

Global Credit Crisis 2008

The Genesis:

An investment bank uses its own money to lend others and invest. It started with the sub-prime crisis. Banks like Lehman, buy mortgage loans from other banks and then package them to sell bonds against the loan pool. Often they add cash to make the loan pool more attractive, so that the bonds can be sold at a higher price.

Example: Suppose mortgage was earning 6%, these bonds are sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. However, when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.

The Acceleration:

Owing to the financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. Thus the liquidity dries up and further leads to something called as “Domino Effect”. For Example:  Suppose Lehman faces redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip.

This is when the crisis spreads from being sub-prime to prime.

Underlying Technicalities:

Many of these instruments are over-the-counter (OTC) instruments unlike exchange traded (like stocks). Here two consensual parties come together and get into a buying/ selling agreement as per their own set rules.

However, this arrangement has a marked-to-model architecture unlike the market-to-market (for exchange traded instrument), which is based on the rules of demand and supply (bid-ask). 

What the bank does is construct a model, feeds the available market price of these variables in the computer, to arrive at what the market price of the OTC instrument could or should be. This is an artificial model-generated price.

The trouble is when the bank actually goes out to sell them, it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument, the loss suffered is far in excess of the mark-to-market loss.

As an Investor:

If you are an investor, sit on cash. Or a better way, invest in Liquid Funds . Or if you are little adventurous, search for other asset classes. Or if you want as much excitement as Bungee Jumping.. Try equity markets..