How index funds moderate investor biases

This article shows why index funds are behaviorally optimal. Specifically, it discusses how index funds moderate certain biases that investors suffer from. This and the cheap beta exposure offered by index funds make them an important part of the core portfolio.

Loss and regret biases
Psychology plays an important role in the investment process - during portfolio construction and at the time of rebalancing.

Consider this. Suppose an investor buys an active fund benchmarked to the Nifty Index. If the fund outperforms the index by 5 percentage points on a risk-adjusted basis, the investor would be happy with her choice. The investor would be, however, unhappy if the fund underperforms the index by 5 percentage points.

The fact is that the investor`s unhappiness from the five percentage point underperformance is likely to be more than her happiness from five percentage point outperformance. This is because the pain due to losses is more than the pleasure from gains. Exposure to index funds moderates this bias. How?

The pain of loss or pleasure of gain is typically relative. The investor will no doubt feel the pain if her portfolio losses 10 per cent in value.

But her pain will be even more if her portfolio underperforms the market by 5 percentage points. In other words, performance relative to the market benchmark is important. And index funds moderate this pain by mirroring the market return.

This is not all. The feeling of regret of investing in equity is lower during market downturns if the investor has exposure to index funds than to active funds. The reason is that choosing an active fund requires an active decision by the investor. And with active decision comes the responsibility of choice. A bad choice leads to higher regret.

Risk psychology
Exposure to index funds also impacts risk psychology. Investors often tell us that active funds are better, as the market has managers with superior skills. We agree. What we wish to reiterate is that such superior managers are not easy to find.
The reason is that fund performance cannot be an indicator for a manager`s skill, as outperformance can be due to good luck and underperformance can be due to bad luck. And the problem is that good or back luck can persist for a longer time than investors can be solvent!

Suppose investors choose an active fund purely on past performance. The superior past performance could prompt the investor to undervalue the risks associated with the investment. This is because the fund manager`s past performance prompts the investor to make unrealistic expectations. But the fund could underperform the next year even if the fund manager possesses superior skills. And underperformance, in turn, leads to regret.

Investors` perception of risk is not so skewed when it comes to market expectations. That is, investors realize that markets cannot continually climb up. This translates into more realistic expectations from the market than from the active managers.
In other words, investors do expect asset prices to reverse direction, but do not expect outperforming managers to turn underperformers. And since index funds merely tail the market, the returns expectations from passive funds will be more measured. Realistic risk perception also helps in effective asset allocation.
ConclusionOur objective was to show why passive exposure is optimal. Readers may also recall from our earlier discussion that index funds also offer cheap market exposure, making it an important part of equity core portfolio. We wish to emphasize that an optimal portfolio should contain both active and passive exposure to the market. Index funds are important. So is alpha return.

Choosing debt options is a balancing act Source: BUSINESS LINE (22-NOV-10)

Even as the equity market had a dream run over the past year, the dull debt market is in for interesting times too. Investors, who hitherto had to be content with traditional debt options such as fixed deposits and provident fund, now have a wider universe of investible options; thanks to the country`s slowly deepening debt market. Besides an array of debt products that mutual funds offer, zero-coupon bonds, non-convertible debentures, corporate bonds and infrastructure bonds - instruments that were often not accessible to retail investors - are the new debt options to hit the market since 2009.

What makes the recent set of options different from the traditional `deposits`? For one, most of the instruments are keenly watched by regulators, thanks to a good number of them being traded on the bourses. Two, being mostly tradable securities, they offer investors greater liquidity.

However, they are not free from the interest rate and credit risks typical of debt offers. For this reason investors may have to survey their options based on four key criteria - safety, liquidity, returns and taxation; the last two going hand-in-hand. Here`s a look at how to evaluate the universe of debt options against the above criteria.

Safety
Thanks to the liquidity crisis in 2008, companies and even financial institutions strapped for funding decided to tap retail investors more actively. For individual investors this means exercising more caution while investing in debt.

While small savings schemes come with a government guarantee and bank deposits are protected by insurance, the credit quality of the borrower may vary significantly in other debt options. Given that companies are from myriad backgrounds, it has become imperative for investors to know the business profile and financial soundness of the borrower.

High safety: On the safety parameter, therefore, the traditional government Post Office Schemes, PPF, NSC and even zero-coupon bonds offered by government-backed apex institutions such as the Nabard come with an almost nil credit risk and offer fixed returns. Bank fixed deposits too can be termed relatively safe, given the guarantee on deposits (including savings account) up to Rs 1 lakh.

Medium safety: Fixed Maturity Plans (FMPs) of mutual funds and secured non-convertible debentures come under the medium-safety category. While FMPs too are subject to credit and interest rate risk, with their close ended nature (locked for a fixed period) and portfolios that are held to maturity, investors can be reasonably sure of receiving the indicative yields of the instruments these schemes take exposure to.
However, investors have to understand the nature of instruments that these schemes invest in. While commercial paper or gilts may be less risky, higher exposure to corporate bonds may carry credit risk.

For instance, FMPs that invested in debt securities of real estate companies in 2007 had a tough time post the realty meltdown, restructuring the debt and getting back the money.

Non-convertible debentures and infrastructure bonds that carry a fixed coupon rate and are secured by the assets of the issuer are also not too risky, provided investors attempt to understand their credit rating and hold them until maturity. However, for those who wish to sell the debentures in the market before their expiry, interest rate risk and liquidity risk are key factors to watch out for.

As bond prices will decline during periods of rising interest rates, a wrong decision to sell bonds in such a scenario may provide lower returns or sometimes even result in capital losses. Besides, given that the bond market in India lacks liquidity, it is possible that investors wanting to sell may be unable to find takers for the entire lot on the stock exchange.

Credit risks in debentures can, to some extent, be understood from reading credit rating reports. All debentures are rated by credit agencies (such as Crisil, ICRA) based on various criteria such as nature and track record of the business, debt-equity levels and capital adequacy. Higher the rating, lower the risk. Debentures of Tata Capital or L&T Finance issued last year are instruments with a high rating.

An instrument below investment grade (as defined by the rater) carries higher risk of default - a clear sign for investors to stay away. Investors holding long-term debentures must update themselves occasionally on the latest credit rating to know if the view on the issuer has changed.

Low safety: Corporate deposits of the high yielding variety are typical examples of high-risk, high-return instruments within the debt category. They often come last in terms of safety. While all corporate deposits are not equally risky, given that a number of deposit-takers do not disclose their credit rating in the application made available, investors are often lured by the high interest rate offered. While choosing from various corporate deposits, investors should do some homework in understanding the business risk of the borrower, track record of financial performance, the debt position and whether the company`s profit can comfortably service interest, besides any history of default. Looking out for deposit schemes of companies whose stocks are also listed may be less of a hassle, as the financial statements and filings pertaining to such companies are available in the public domain. Investors can also look out for companies with consistency in earnings rather than flashy performances.
LiquidityWhile the traditional options are high on the safety radar, it is the new-age options that often top the liquidity list. Open-end debt-oriented mutual funds are the most liquid options, given the ease with which these schemes can be redeemed, especially when there is an emergency. However, most of them have a short period of compulsory holding, any redemption within such period being charged an exit fee.

The holding period, though, is negligible for liquid and short-term funds. For this reason, these are most suited for any temporary parking of funds, at the same time earning more than savings bank interest rate.

Debentures: Some debentures and bonds are listed in the market as soon as they are issued and can be sold in the bourses provided one holds it in demat form. Shriram Transport Finance or Tata Capital NCDs are examples.

In fact, even if one missed the initial issue, they can be bought in the market, provided the investor is well-informed on debt markets and can time the call based on yield movements. Liquidity in these instruments is not uniform and some may be traded more frequently than others.

For investors wishing to hold these the debentures/bonds for a while but not until its maturity there are other options as well. Sometimes debentures/bond come with a lock-in period before they can be traded.

This is typically for almost half the tenure of the bond. Investors may either sell it post such lock-in or alternatively go for a call/put option if such an option is available at the time of applying for the bonds. The recent SBI Bond offered a call option, where it may choose to buy back the securities after five years. If it fails to do so, the bond promises an additional interest rate as compensation. A few other debentures also come with put options, where the investor has the option of redeeming the money.

While the traditional deposits are not very liquid, an exit from them is still possible. Most bank and corporate deposits allow premature withdrawal subject to a minimum lock-in period. Some even allow part withdrawal without affecting the interest earned on the rest of the capital.

Illiquid: Public provident funds can be termed illiquid as even a part withdrawal is possible only in the seventh financial year from the year of starting the account. The sum too is restricted.

Others, such as the Post Office Senior Citizens` Scheme and Post Office Monthly Income Scheme can be withdrawn after one year but are subject to penalty. However, loans can be taken against products such as PPF (from third year) and post-office time deposits, subject to certain conditions on the amount available as loan.

5 ways to withstand inflation

A pretty humorous but powerful way of defining inflation is, ``it happens when everything gets more valuable, except money!`` 

Inflation or simply, the consistent increase in the prices of basic goods and essential services squeezes out every bit of penny from the hands of common man. Especially in a high growth and developing economy like ours, inflation would continue to remain a worry for all. In the past, we have had governments being given a pink slip owing to steep rise in onion prices and even a bandh this year to protest against inflation. While efforts are made by the central bank and government alike to keep the price rise under check, we need to safeguard ourselves against the demon of inflation which smartly keeps reducing the value of our savings.

It is never too early or too late to invest 
Over a period of time, wealth creation is an eventuality and concern, not just to surpass the price effect but also to support your lifestyle needs particularly, post retirement. If one starts to invest early in life, the magic of power of compounding would help you grow your net worth sizably. Even if you haven`t started yet, a disciplined approach and regular investing would bring handsome gains. 

I. Why not deposits
In order to restrain the inflationary pressures, the central bank hikes the interest rates. As a result, depositors enjoy higher interest rates on their fixed term deposits. But here lies a catch. Inflation reduces the real value of your money. For example, you bought a food item at Rs 100 in 2009. Assuming an average food price inflation of 10%, this food item will cost you Rs 110 today. Thus, though your expenses are still the same, you are spending more. The same principle applies to your deposits which should yield you more returns. In effect, your fixed deposit rate (x) should be more than inflation (y) to effectively beat the 10% price increase. Therefore, your real or actual return is (x-y) should match or exceed the `inflated` cost of living which is often not the case. 

II. New pension system (NPS)
Today`s generation wants to retire early, has limited or no post employment pension and intends to live a hedonistic life. Building an adequate corpus to take care of expenses and a comfortable livelihood after retirement is important; moreover, because inflation erodes the corpus value. Therefore, an extremely cheap annuity plan like NPS is a viable option. 

III. Diversify into equity asset class
As proven by the past market cycles, despite the fluctuations in the short-term, the returns generated from equities supersede other asset classes in the long term. Thus, the portfolio strategy to beat inflation is significantly aided by allocation to equities. 

Plus, it is better to have a diversified portfolio of stocks or invest in a diversified equity fund without a sector or industry bias. Contrary to the depositors, higher borrowing rates by banks deeply impacts the credit requirements of corporate and individuals. So sectors such as real estate, infrastructure and power which require huge liquidity to supplement their long gestation plans are greatly affected. Despite this, there are sectors which source raw materials such as food grains and industrial metals, and offer essentials like utilities, health and personal care on which individual and industry depends on, would continue to function the same way. In fact, companies that produce these primary goods would benefit from the price rise. 

IV. Alternate options: Commodity investing
Investing into agriculture-based funds is another option. There are also commodity funds which invest in companies related to precious metals (read gold), energy stocks, metal and mining industry. But commodities prices are highly cyclical and are subject to macro-economic policies, geo-political environment, and consumption demand. In case of global commodity based funds, currency risk is also applicable. However, aggressive investors can include these funds in their supplementary portfolio. 

V. Gold - Traditional hedge
Indians are aware and have a significant allocation to gold albeit in jewelry form. With the emergence of ETFs and gold feeder funds, people are gradually looking at the yellow metal for investment. It also serves as a hedging tool during uncertain times. Presently, the steep rise in gold price is owing to the slow recovery in the developed markets. However, one has to bear in mind that gold does not generate interest income or pay dividends so it is more of the appreciation in value that would actually benefit your portfolio.

Health is wealth: Put first thing first

It is rightly said, ``Health is Wealth``. But truly speaking how many of us are really serious about this. Today, when everything is uncertain, nobody can be sure what will happen tomorrow. We all are aware that medical bills are high and getting still higher. Still we do not buy health insurance plans. Health insurance is way of covering you and your family against any medical emergency arising out of any diseases or illness or accident. In India health insurance premium is considered as expense. This is because we do not give importance to eventualities. It is also true that, as the age of an individual increases, the medical bills are likely to increase and become a burden on the family. Some time entire family collapses because of this financial burden. We need to think seriously and act immediately upon it.

When we meet clients, usually we find one or two life insurance policy in each & every home, but the health cover is mostly missing there, not only because of lack of awareness but also because of unwillingness to pay the premium from customer side. At present less than 10% of total population have their health insurance plan. Data shows that 30% of people with heart problems are less than 40 years old. Diabetes, blood pressure and cholesterol are also very common in younger age. Stress level at work, habits and increasing life style illness also add to physical & mental pressure. Better we take early step to cover our self and our family before it`s too late.

A mediclaim policy covers hospitalization expenses for the treatment taken for disease or illness or accident. It also covers pre and post hospitalization expenses up to certain days and certain limit of sum assured. These limits differ from company to company depending upon the policy and sum assured.

In today`s scenario health plan of 50,000 or 1 lakh sum assured will not suffice. Individually we require minimum 3 to 5 lacs health cover. You can also buy a family floater with an extra top up plans, which will really help you in bad days. Now most of the companies also offer cash less facility if the patient is hospitalized in network hospital. Thus, we can concentrate only on illness of the patient and save time & energy from raising funds from friends and relatives.

Other benefits
> Cumulative bonus of 5% to your sum assured for every claims free year
> Family discount of 10% is applicable
> Health check-up in designated centers or reimbursement up to Rs 1000 at the end of continuous four claims free years.
> Income tax benefit on the premium paid up to Rs 15,000 as per section 80-D of the IT Act. You can also claim for the premium paid for your parents separately up to Rs 15,000 ( Rs 20,000 in case of senior citizens).

General exclusions
> All diseases/illness/injuries existing at the time of proposing this insurance
> Any disease contracted during the first 30 days of commencement of the policy
> Certain diseases such as hernia, piles, cataract, removal of gallstones or renal stones and sinusitis shall be covered after a waiting period of 2 years
> Non-allopathic medicine
> Congenital diseases
> All expenses arising from AIDS and related diseases
> Cosmetic, aesthetic or related treatment
> Use of intoxicating drugs, alcohol 
> Joint replacement surgery (other than due to accidents shall have a waiting period of 4 years)

I also advise my clients to go through the exclusions and the limits of the cover, so that there should not be any problem in tough time. I personally believe that role of an agent/advisor is more important in claim settlement in health insurance compared to life insurance, because claim comes very frequently in health insurance. I also advice my clients to buy the health plans from general insurance or health insurance companies instead buying it from life insurance company. Today many life insurance companies also offers these plans, but you are advised to stay away from this.
A healthy life means many more working years and chance of wealth creation and financial freedom in your life.

Establish goals, don`t leave the future to chance Source: BUSINESS LINE (29-NOV-10)

I am 33 years old, married and have a five-year-old daughter. My wife is aged 30 and is employed. Together we have a take-home salary of Rs 1 lakh per month. I live in a joint family and my parents are independent.

My monthly expenses are Rs 15,000 and rest of our incomes is used to repay home loan, pay into investments, meet the annual insurance premiums and as savings for our international tour every year.

To meet my daughter`s education and marriage I have taken few insurance plans and the maturity proceeds of the plans would take care of both the goals. Recently I have availed a home loan for tenure of 10 years and our outstanding balance is Rs 25 lakh. To protect the home loan I have taken decreasing term insurance for the outstanding. Besides that I have taken a term insurance for Rs 70 lakh and my wife is covered for Rs 45 lakh.

As our parents are hale and healthy, I assume my life expectancy as 80 years. I wish to work till the age of 50 and at the time of retirement I wish to have a corpus of Rs 3 crore to manage the rest of my life.

For retirement, I am investing Rs 16,000 through SIPs in mutual funds such as HDFC Top 200, DSPBR Top 100, IDFC Premier Equity Plan, Reliance Opportunities, and Reliance Regular Savings. Apart from that, my portfolio has 12 schemes.

Beside mutual fund investments I have direct exposure to equity in blue-chip stocks and its current value is Rs 5.6 lakh. Based on the investment, please suggest if I am on track towards achieving my goal.

My current PF balance is Rs 5 lakh. We are covered by company group health insurance. But to be on the safer side I have taken a floater policy for a sum insured of Rs 5 lakh.
- Amit
Solution
A very small percentage of individuals in the age band of 30s plan well in advance towards goals such as education and marriage of their children. It`s nice to see your portfolio and you have attempted to reach the target not with risky equity assets, but through insurance.

But investors do need to understand that when your investment goals are long term in nature, instead of trying to reach your goals through debt it`s advisable to add equity component to keep cushion to meet unanticipated increase in the target amount.
Investors should keep in mind that debt investment through insurance should be a part of asset allocation and it should not be a primary source. The disadvantage with insurance investment is that to protect the life insured it needs to comprise on the return and it eventually increases your contribution towards the goals.

Retirement
It is true that without financial goals we would be leaving our future to chance. To tackle the ambiguities of future, establishing goal is mandatory.

If the monthly contribution required is higher than available surplus, investors might tend to take higher risk that eventually leads to more chaos. While calculating the future requirement it may be prudent to take long-term average inflation and provide for (any) increase in standard of living.

Take inflation at 7% and provide 2% for increase in standard of living. For instance, in your case, your current monthly expense of Rs 15,000 or Rs 1.8 lakh per annum if inflated at 9% (7% plus 2%) would make your annual requirement at the age of 50 to be Rs 7.8 lakh (corpus Rs 1.74 crore).

So your plan to build a retirement corpus of Rs 3 crore is on the higher side to meet this target you ought to save monthly a sum of Rs 56,600 at a return of 10%. Your current surplus would not permit you to do so.

If you want to build a corpus of Rs 1.74 crore you ought to save a sum of Rs 23,500 per month (inclusive of the existing SIPs) at a return of 10% after adjusting your current investment of Rs 10 lakh growing at same 10% for the next 17 years.
To meet your requirement, your retirement corpus should earn an interest of 2% above inflation.

For these calculations we have not taken your PF accumulation. That can be utilized to meet a shortfall in target.

Investment
Your current portfolio consists of 17 schemes and several of these schemes` investment objectives have overlaps.

It is generally advisable to restrict the number of schemes in the portfolio to 4-5. Your SIP investments are in the desired schemes and suggest that you continue with that.
Sell the remaining schemes and redeploy the proceeds in HDFC Top 200.

As you have taken adequate risk covers, don`t add term insurance to your portfolio.
Finally, it is advisable to review your portfolio at least once in six months to assess performance and to accommodate any change in lifestyle.

Portfolio ETFs for lifecycle investment Source: BUSINESS LINE (29-NOV-10)

Author: B. Venkatesh

It has been a while since ETFs were introduced in India. Its popularity is yet to grow, despite obvious benefits. Many look at ETFs as an alternative exposure to index funds. The question is: Can ETFs be used to generate cost-effective alpha and beta exposure for the investors?

This article discusses how ETFs can be used effectively in the core-satellite portfolio. It first explains the benefits of ETFs. It then discusses the process of using ETFs for beta and alpha generation. ETFs on asset classes such as bonds and commodities, which when introduced, could offer complete portfolio solutions for lifecycle investment.

Arbitrage and cash drag
ETFs moderate the cash drag and the price arbitrage problems faced by open-end and closed-end funds respectively. Consider the open-end fund. Cash drag refers to the lower returns that a portfolio may earn because it holds cash to meet daily redemption requirements of unit-holders. Closed-end funds, on the other hand, trade at a discount to the NAV.

ETFs sidestep the issue of cash drag by redeeming units in kind. That is, institutional investors do not get cash when they redeem units. They instead receive the underlying shares that constitute the benchmark (say Nifty Index) on which the ETF is based.
Likewise, ETFs reduce the NAV discount by allowing institutional investors to engage in arbitrage when the market price of the ETF is different from its NAV.

Besides, ETFs carry lower management fee compared with even passively-managed open-end funds. All these features make ETFs a desirable investment in any portfolio.

Beta ETF
ETFs are primarily passive structures, though some active ETFs do exist in the US. ETFs, therefore, logically form part of the passive equity core within a core-satellite portfolio.

The core-satellite framework separates the beta exposure from the alpha mandate.
That is, the core portfolio contains pure beta or market exposure while the satellite strives to generate alpha or risk-adjusted excess return over the benchmark index.

We prefer ETFs on broad-cap indices such as the S&P CNX 500, as it helps investors get cheap market exposure to equity as an asset class. The Indian asset management industry does not yet offer such products. Investors have to therefore, settle for a passive exposure to a large-cap index such as the Nifty Index for their equity core.

Note that investors face a similar choice problem when they use open-end index funds.
We next discuss how ETFs can be used to generate excess returns over the benchmark index.

Alpha ETF
ETFs can be used to generate alpha in two ways. One, investors can buy-sell ETFs to generate excess returns. This is possible because ETFs are traded like stocks, unlike open-end funds that can be bought from a mutual fund complex only at the end of the day.

And two, ETFs can be used to back out the beta exposure in a fund. Suppose an investor buys a mid-cap fund.

Note that the mid-cap contains both alpha and beta exposure while the mid-cap ETF has only beta exposure. The investor has to first compute the relationship between the mid-cap fund and the mid-cap ETF.

Then, the investor has to use this relationship to short appropriate units of mid-cap ETF. Shorting beta-adjusted mid-cap ETF neutralizes the market exposure of the mid-cap fund.

And what remains is the alpha return! At present, investors can set-up such ETF alpha strategies in the banking sector and in large-cap stocks.
ConclusionThe use of ETFs in the satellite portfolio is only constrained by the availability of products in the market. While investors can now take exposure to gold ETFs, alternative and synthetic ETFs such as commodity ETFs (besides gold) hedge fund ETFs or Swap-based ETFs are yet to be introduced in the country.

Taken together, these products can help investors create a portfolio of ETFs to completely map their lifecycle needs.

Retirement planning: When`s the right time to start?

Author: Anil Rego
Of all the financial goals that we plan for in life - be it planning our children`s education, purchase of our house, a vacation, or buying a car - retirement remains a distant dream and also the one which occurs last on our priority list so we either avoid planning for it or push it to the next time. So people always wonder what would be a good time to start planning for it.

Only when we look at the numbers required in terms of money for retirement, one realizes that it could be a tad bit late or that it should have been done before. Sometimes people even drop the retirement planning by saying that they probably missed the train.

So what is the right time for retirement planning, we believe that any time between the ages of 25 to 35 is a good time to plan for retirement, but this does not mean that one should not plan for retirement after the age of 35. The sooner you start the better you can plan.

Let`s take an example of retirement planning at three different stage of life.

Chinmay is 25 year old professional. He works with an MNC for last 3 years. He decided to retire at the age of 60 years. Based on that, he calculated his monthly expenses and came up with a pension requirement of Rs 30,000 a month as of today. After doing analysis, he comes to know that inflation is a biggest enemy for his retirement; the expenses of Rs 30,000 today will certainly not remain the same after 35 years. Hence, it becomes pertinent to accommodate inflation as well to arrive at the corpus required for retirement, the investment pattern required to achieve the set corpus would entirely depend on when he chooses to start investing.

Below table shows the calculation for the retirement planning for different age group people.

House hold budget: - Rs 30000 a month
Year of retirement -60 years
Inflation Rate: - 6% p.a.
Expected Returns: - 12% p.a.

Considering, a large part of today`s expenses would not be there once one retires (EMIs, lifestyle expenses, hopefully even your investment commitments) and since most of the goals including owning a home, a car and children`s education would be taken care of; we assume that the only expenses that remain would be those pertaining to running household such as grocery, utility charges, adhoc expenses etc.,. Here`s a scenario analysis of impact of inflation, investment tenure and the resulting investment pattern.

Age	Monthly Expenses @ Retirement	Corpus Needed @ Retirement	Lumpsum Investment	Monthly Investment
25	230,583	41,291,957	782,050	7,971
30	172,305	41,291,957	1,378,240	14,258
35	128,756	41,291,957	2,428,929	25,807
40	96,214	41,291,957	4,280,604	47,757

A look at the table above suggests that the early you start the better you plan, you can build the corpus slowly and steadily. At the age of 25 or 30, you can easily manage to invest the amount and achieve the corpus.

The decision to retire is not an easy one, especially if you need to plan it before you reach your prime and even thought about other important priorities such as a home, a car or your children. However, it is a decision that we need to take because retirement is a certainty though it might be far out in the future.

Take aways…
> Recognize that retirement is as important a financial goal just like buying a home, a car or your children education

> It is extremely difficult to plan for retirement early since you are not sure about how to proceed since this goal is far out in the future - take professional help if required

> Starting early, with however little contribution, you could be on target to achieve your retirement goal since the power of compounding would work in your favor and you have greater chance to getting to the targeted corpus

> You just need to take care of your basic expenses post retirement since your profile would change meaningfully

Five investment ideas to beat inflation Source: BUSINESS LINE (06-DEC-10)

For most of us, inflation only conjures up images of sky-rocketing onion or milk prices that can throw the household budget into disarray. But have you thought about the serious damage that inflation can inflict upon your long-term wealth? Even a small but sustained increase in inflation rates can completely wreck your carefully constructed plans for buying a home, funding your daughter`s engineering degree or even living it up after retirement. Prepare for 8%.

The risk of inflation upsetting your financial plans is not theoretical; it is very real, for two reasons. One, inflation in India is usually discussed in terms of the Wholesale Price Index or WPI, which captures product prices at the factory level. But it is the Consumer Price Index (CPI Industrial Workers) that better reflects products and services used by middle-class consumers. Annual inflation in the CPI (8%) has consistently stayed well above WPI (6%) in the last five years. Two, inflation has climbed steadily in recent years, with a rising middle-class stoking demand for everything from apartment blocks to vegetables. Therefore, while financial advisors in India have traditionally used a 5% inflation rate to construct long-term investment plans, inflation today is already at twice that level. So what inflation rate should investors budget for over the next decade or so?

A study of inflation trends over the past 30 years shows that 8% would be a realistic number. Studying 30-year data for CPI (using ten-year rolling returns) reveals that consumer prices rose at over 8% annually almost 60% of the time since 1980. Inflation stayed at 5% or less only 5% of the time. If inflation itself is to reduce the value of money by 8% every year, how should you rejig your portfolio to keep ahead of it? Here are five ideas that may help investors win the battle against inflation:

> Stop shunning stocks

Whether inflation hurts or actually helps stock prices has been the subject of a wide academic debate. However, a study of real-life trends in the Indian stock market shows that stocks are the only asset class that have done a decent job of delivering `inflation-plus` returns to their investors, with any degree of consistency, over the last 30 years.

A rolling-return analysis of the BSE Sensex vis-a-vis the consumer price index shows that for investors who held on for ten years at a time, the BSE Sensex beat the consumer price index on nearly 80% of the occasions.

Yes, there were certain ten-year periods (for instance, between 1992-93 and 2002-03) where stocks actually declined and left investors high and dry. But the big gains notched up in the good years would still have left investors in a comfortable position had they waited a couple of years to cash out.

In contrast, gold, the retail favourite did not match inflation nearly 50% of the time! Investors who bought gold for the extended period between 1987 and 1995 would have found the value of gold holdings not keeping pace with inflation rates over the next ten years. In recent years, however, gold has done a splendid job of beating inflation, thanks to the spurt in returns on the yellow metal. Fixed deposits, where most people park the bulk of their savings, have not delivered positive `real` returns on most occasions.

All this suggests that stocks are a must-have in the portfolio for anyone saving money towards any 10-year plus financial goal. For a person with a debt-only portfolio earning a return of 8% now, allocating 20% to stocks may lift returns to a respectable 10%, assuming stocks deliver 16% over the next ten years. Beating inflation by a bigger margin will require a bigger stock component.

> Debt-plus funds

Those not comfortable dabbling directly in stocks can take the mutual fund route. Monthly income plans that add a dash (15-20%) of equity to a debt portfolio are one option. However, only a handful of them have trounced inflation over the past five years -  the category as a whole has managed a 8.4% return. Reliance Monthly Income Plan, CanRobeco Monthly Income and HDFC Monthly Income Plan are a few funds that registered a 11-12% annual return.

Though they come with higher risk, balanced funds (which use a 65:35 combination of equity and debt) seem a much better option for conservative investors seeking to beat inflation.

One, all of the 15 balanced funds that have a ten-year record have comfortably beaten a 9% inflation rate, their returns ranges between 13 and 27% and averaged 17%  for ten years.

Two, returns from balanced funds, as they are treated as equity-oriented funds, suffer lower tax compared to monthly income plans. Thus they may yield higher effective returns for investors in the higher tax slabs. Yes, balanced funds will see their values plummet in any stock market meltdown. But regulated equity exposures and a 10-year plus holding period should mitigate this risk to a good extent.

> Real estate & rents

Though there is no property index to support this, inflationary periods in India have usually been accompanied by rising prices of real estate. Real estate investments help you keep ahead of inflation in two ways. One, as a home tops the must-buy list for most Indian salary-earners, property prices usually move in step with income levels (a key inflation driver) over the long term.

Two, rents on residential property, especially in the cities, also tend to march with inflation. Therefore, owning a second home and renting it out, ensures that a portion of your monthly income is automatically benchmarked to inflation over the next decade or so.

Most Indians already have a sizeable portion of their wealth locked up in property, thanks to the value of their own homes. A self-occupied home allows the owner to protect himself against inflation in his monthly rent outgo. However, those who have little or no investments in property should actively consider real estate investing to counteract the impact of inflation.

Buying plots of land, an affordable home in the suburbs or real estate funds to participate in property price appreciation are options. However, investors keep tabs of their overall portfolio structure while doing this - having over 50% of your total wealth invested in property would be tantamount to putting all your eggs in one basket!

> Make use of leverage

Ever thought about why the EMI (equated monthly instalment) on the flat you bought five years ago seems so manageable today? That`s because of inflation too. One of the key side-effects of inflation is that, by steadily nibbling away at the value of a rupee, it puts the borrower at a distinct advantage over the saver in the long run.

The EMI of Rs 30,000 a month on the home loan you took five years ago may have amounted to 50% of your monthly salary in 2005. But if your salary itself has kept pace with inflation (growing at 8% a year), then you would today be shelling out only one-third of your monthly salary as loan repayment. The appreciation in the market price of your home would also have increased your comfort levels in paying off your debt.

Yes, higher inflation may push up the interest rates if you have a floating rate home loan. However, the tax incentives on home loan repayments, on top of the relatively low interest rates on home loans, still make leverage a particularly good option to fund your property purchases.

Now, we are not suggesting that maxing out your credit card while shopping or borrowing to bet on IPOs is an inflation-beating idea! However, judicious use of loans to fund long-term goals such as acquiring a degree or purchasing property does help you win the battle against inflation.

> Stock up to win the inflation battle

When it comes to beating inflation, all stocks are not equal. The following points may help investors choose stocks that can inflation-proof their portfolio.

Stick to blue-chips: Though mid-cap stocks tend to deliver bigger returns than large caps in a bull market, mid-sized companies in India have historically proved more vulnerable to rising raw material prices than large ones. That makes them less well-placed to deliver profit growth in high inflation scenarios. For instance, the Sensex companies in India have traditionally enjoyed over twice the profit margins of their mid-sized peers, given their market leadership, procurement strengths and pricing power. Thus, investors looking to add a stock component to their mainly-bond portfolios may add Sensex/Nifty ETFs or funds to get the equity exposure.

Lean towards commodity processors: A scenario of high global inflation usually puts commodity processors (like Tata Steel or a Hindalco) at an advantage over converters of commodities (like a Welspun Gujarat or an Apollo Tyres).

The former benefit from high commodity prices while the latter usually lose.

Look for pricing power: A high inflation scenario usually forces companies to look for avenues to pass on higher input costs to their customers without hurting demand. Companies that have high pricing power usually hold a monopoly or dominant market shares in their category, operate in niche markets or offer premium products that are in high demand.

In recent times, companies that market products directly to consumers (consumer durable and auto makers) have enjoyed good pricing power even in an inflationary scenario, owing to strong consumer demand.

Industrial product makers who sell to other businesses have been forced to absorb higher costs. A company`s operating profit margins are the best test of pricing power.

Cover for your loan

Harshad was a young professional working in a multinational company. He took out a home loan and bought house he was keen on. Unfortunately, a year later, he met with an accident and was bedridden for over six months. He was thus not able to meet his EMI payments, and had to eventually let go of his house. Such an unfortunate situation could have been avoided had Harshad gone in for home loan insurance.

What the term means
Loan protection insurance, or loan payment protection insurancehelps you protect your monthly loan payments if you become unemployed or suffer an accident or sickness. Loan insurance is offered mainly for home loan borrowers. However, some banks offer loan insurance for personal and auto loans too. Under a loan insurance cover, the lump sum amount reduces as the outstanding loan decreases as per the loan schedule.

Benefits
Taking up a loan insurance means that during tough times, you``ll have a cover to take care of your EMIs or of the outstanding loan amount. It is especially useful in case of death or disability due to an accident or sickness, or in case of job loss. It reduces the burden on your family in case of any unfortunate event that befalls you. They would be protected from the financial trauma of paying off the loans. In case of a joint loan application, a joint loan insurance plan can be taken which will effectively cover you and your partner. Both will have the reassurance that if either of you should be faced with redundancy, illness, have an accident or even die, your repayments will be made for you.

Premiums
Premium amounts vary from bank to bank and depend primarily on the following factors:

Age: premiums are usually higher for older people

Loan amount: higher the loan amount, higher the premiums since the bank has a higher liability in such cases

Loan tenure: If the repayment period is longer, premiums are also higher

Medical records: If your physical health is good, the premium gets reduced. . However, if you are suffering from any kind of serious ailments the premium will rise.

Things to keep in mind
Loan insurance is something that you need to give careful thought to. You need to do checks based on:

Loan insurance cover: Does it cover death by accident or death by any other cause? Does it cover temporary disability only or does it cover permanent disability as well?

Eligibility: Check out eligibility criteria for the insurance. Find out whether the loan needs to be of a certain amount.

Payment of premium: Check whether you can pay the premium as part of the EMI or if it has to be made as a lump sum payment

Medical check-ups: Check whether a medical check-up is necessary in all cases.

Tax benefits: Yes, there are tax benefits that you can get with such kind of insurance. Since you are paying a life insurance premium, you can get deduction under Section 80C. However, if it is clubbed with your EMI payments, you lose the insurance benefit.

Leverage investment: Good for real estate, not for equity Source: BUSINESS LINE (06-DEC-10)

Real estate investment is typically leveraged. Investors take 70-80% bank borrowing against 30-20% equity or own funds. Leverage improves returns if asset price appreciates.

This article explains the benefits and the risks of a leveraged portfolio.

It then shows why leverage may not be optimal for the passive core portfolio. Discerning investors could, however, employ some leverage through active futures position as part of their satellite portfolio.

There are obvious advantages of using leverage. Suppose an investor borrows Rs one lakh at 8% interest and earns 10% return on a total investment of Rs 1.5 lakh.

The return after paying interest amounts to 14% (Rs 7,000 divided by Rs 50,000). This compares well with just 10% return the investor would have earned if she had invested only her capital of Rs 50,000.

Now, suppose the investor had Rs 1.5 lakh of her own money but chose to invest only Rs 50,000 while borrowing the rest for the above investment. She now has the balance money available for further investments. Leverage, thus, helps investors `extend` their investments to other asset classes as well.

But beware. There is a flip side to leverage. It magnifies the effects of negative returns-compounding.

In the above example, suppose the investment of Rs 1.5 lakh declines 10%. After paying for interest on borrowing, the investor would suffer negative returns of 46% on the investment of Rs 50,000!

The question then is: How useful is leverage in equity portfolio?

We define leveraged equity as one where investor uses futures to take the required exposure. An investor who wants to buy, say, Nifty Index Fund can instead buy Nifty Futures, as it requires only a fraction of the money needed to take the exposure.

There are several problems with such a leveraged investment. One, there is a mismatch in time horizon if the investor uses futures to replicate beta exposure in the equity core. This is because equity core is set-up for specific investment horizon, while futures are short-term contracts. The investor has to religiously roll-over the contract every month to continue the exposure till the required investment horizon. This exposes the portfolio to roll-over risk -  the risk that the next month futures contract price will be higher than the current month. And two, there is a difference between real estate leverage and equity leverage. Real estate typically earns rental income while the only source of return from futures contract is capital appreciation. Such sole dependence on market price for returns magnifies the negative returns - compounding effect on leveraged equity, as illustrated above. This factor assumes importance because investors typically tend to suffer from loss-aversion effect. That is, when faced with price declines, investors tend to hold on to their loss-making position because of their unwillingness to realise losses. Such behaviour could prevent the portfolio from achieving its investment objectives.

Conclusion

Equity leverage is not always harmful. Discerning investors could allocate a proportion of their total assets (not more than 5%) to active futures position. Such exposure should form part of the active satellite portfolio, not the passive core. It is important to control risk, yet generate higher returns from such active trading.

Some investors prefer to borrow money to leverage their risk-parity portfolio (refer this column dated October 3, 2010). We do not encourage such leverage because of its downside effects. Real estate leverage may be good, as long as the rental income pays for the mortgage. This is not the case for other assets, especially leveraged equity using futures. Leveraged portfolio is, hence, best left for institutional investors.