Investing:Think about Liquidity,Safety,Returns,Risk,Tax

In our post What is Investing? we discussed investing is plan, a very personal plan based on your preferences, needs. And your investment plan will then determine the different types of investment vehicles you will need. Your investment plan has to be unique just like you.

The idea behind investing is to put money to use in such a way that it is likely to earn more money i.e make your money work for you. For example:

  • If you buy a thing say,gold coin/house today. After some time (maybe) it’s value will increase. Then when you sell it at higher price you have made money
  • If you lend your money to bank saying that you will need it after 2 years (called as Fixed Deposit). The bank will give you some money called as interest for allowing it to use. So at the end of two years you get your money back with assured interest.
  • If you put money in a business(by buying shares) and the business makes profits. Then the business(may) pay you part of profits for investing in the business(called as dividend). The value of business may increase. Later you can sell your share of business and get your money back along with some more(maybe).

Did you see the use of word maybe or likely in above examples. It may happen that you may not get your money back. For example : One buys Gold at Rs 20,000 after 6 months it’s value becomes Rs 18000. Then the person’s money has not grown. Or If one invests in business which fails then the person may not get any money back. So one has to be careful of investment choices. As the legendry investor, Warren Buffet, has said “Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1″

Different Ways of Investing

Gone are the days of assured returns, limited choices, insulated capital markets and high risk-free returns. Today, one has to deal with increasing complexities of the market and variable interest rates on traditional savings products. There are many ways in which you can invest your money which can be divided into following categories

Lending it :If you lend money to government, banks or business by buying their bonds or opening fixed/recurring deposit account , these organizations will pay interest for allowing them to use your money. Your money thus can earn steady returns by the way of interest. But the returns may be less than the inflation. For ex: A fixed deposit may pay 8% interest for a year but the inflation is 9%. Then the real return is negative.

Buying share in business capital and profits:You can invest money in buying share in the business of companies called as stocks or shares.Your money can grow in two ways

  1. The company may pay you a dividend – your share in profit.
  2. The shares of the company may increase in value.

Because of complexity of a business, one must be careful of investing in stocks. Stocks are high risk instruments, with the potential to give high returns. If business you invest in is not good then your money may also get wiped out.

Buying an item of value: You can buy things that may increase in market value, such as gold, land, house or collectibles like a art or stamp . You can make money by selling for more than what you paid. But it may also happen that the value of thing you bought goes down then you may get less than what you paid.

Things to consider before buying any investment Product

Any investment product should be bought with following things in mind: Liquidity, Safety, Returns and Taxation. 

Liquidity–

Liquidity  means how easy or quickly you can convert investment product to cash i.e  how accessible is the your money invested in that product. The most liquid asset is cash as it can always be used easily and immediately. Ref:Investopedia:Understanding Financial Liquidity

  • Fixed Deposits are less liquid, because there is usually a penalty for withdrawing it before their maturity date.
  • Stocks, Mutual Funds are are considered fairly liquid as they can be sold anytime the stock market is open, and the cash will be available within few(three) working days. Shares are said to be liquid if the shares can be rapidly sold which depends on the level of interest that investors have in that stock ex:Stocks of Infosys, TCS are considered to liquid but shares of Jaybharat Textiles there was no trading on the stock in month of Dec(Ref:EconomicTimes:Rise in illiquid stocks in the market fuel liquidity crisis-Dec 2011).
  • On selling coins, stamps, art and other collectibles you might get full value but it could take a while to find another collector, even with the internet easing the way.
  • If you go to a dealer instead, you could get cash more quickly, but you may receive less of it. It can take from several weeks to many months to turn a real estate investment into cash.

Safety

The biggest risk in investment is the risk of losing money or part of the money that has been invested. When you choose to make a safe investment it means your main investment objective is preserving principal. It may mean that the investment provide you with less income or growth. For example, if your investment is earning 4% a year, and inflation was 7% a year, even though your principal is safe, you are actually losing purchasing power.

  • Investing in a Fixed Deposit(FD) is considered to be safe at least till 1 lakh of rupees which is covered under Deposit Insurance & Credit Guarantee Scheme of India(DICGC). For details on DICGC  you can refer to RBI:FAQs on DICGC. So in case of  Fixed Deposit the chance of losing money is less, almost NIL.
  • But investment in Stocks or Mutual Funds are dependent on the market. So if the market falls you may lose a part of your money. For example those who invested in JM basic fund in 2007 would have would have lost 9.56% by 2012. Hence often we see in Mutual Funds advertisements Mutual Fund investment are subject to market risk please read offer related document carefully before investing. Stocks also suffer from lack of safety. The investors who had invested in Reliance Industries in between Apr 2010- Apr 2012 lost 32%.
  • The Indian residential real estate market is growing,fed by a huge domestic demand. Real Estate in India fluctuates but are still safe and profitable. Unless you are involved with land shark like Khurana in Hindi movie Khosla Ka Ghosla.(2006) whereKhurana (Boman Irani) squats on K.K. Khosla’s (Anupam Kher) land bought with the latter’s lifetime savings and demands more to let him have it back.

Returns

Investments are made for the purpose of making money grow or generating returns. Safe investments often promise a specified but ‘limited’ return. Those that involve more risk offer the opportunity to make  or lose a lot more money.  Typical returns expected from various financial investments are:

  • Fixed Deposit, Recurring Deposits, Government Bonds,Corporate Bonds, Debt Mutual Funds: 5-10%
  • Shares and  Equity Mutual Funds : around 10%
FD rates Sensex rates since 1991

FD rates Sensex rates since 1991

CapitalMind:Nifty, Sensex, Gold & Silver Long Term Returns(May 2011) has monthly, annual returns of Silver, Gold since 2003, Sensex since 1981 and Nifty since 1994. Investing in any product is a trade off between Risk and Returns. Let’s look into the Risk and Return.

Risk and Returns

In money or financial terms Risk means the possibility of losing money. Why would people take risk? Higher risk usually brings with it the possibility of earning more money i.e higher returns . While investing we need to do a tradeoff between Risks and Returns. An example of trade-off is choosing Traveling vehicle which is a trade off between time and money. Traveling by planes are faster but more expensive than traveling by train.

Usually there is a direct relationship between risk and return. High risk, high return channels are growth channels that help you build wealth by enabling your invested money grow significantly over a long term. Low risk, low returns investment generally assure steady but smaller returns, helping to build wealth slowly but steadily. Commodities like gold, silver or land are traditionally known to rise in value along with inflation and hence secure your purchasing power despite inflation.  Various investment channels based on risks and returns.

Risks
No one would Stocks/Shares,
High want to use this Land/Art,
Equity Funds
Bank Deposits , Looks too good
Post office Deposits, to be true? It is.
Low Bonds, Practically this box
Debt funds does not exists
Low High
Returns

Everyone wants highest return but with minimum risk but as we know if wishes were horses beggars.. 

 Taxation

India has a well-developed tax structure. We directly(ex:income tax ) or indirectly(ex:service tax) pay taxes. Indian tax laws have various rules and regulations, and these are amended time to time. Understanding Taxation on investments is very important as Tax payable on the earnings/returns has an important role in deciding on the suitability of an investment opportunity. Knowing the difference can mean a bigger tax bill if you’re not careful. For example:

  • If you buy stocks/equity mutual funds.  If you sell them within one year you would have to pay Short Term Capital Gains(which is 15% in FY 2012-13). But if you sell it after one year you will not have to pay any tax. Basics of Capital Gain deals with Long Term and Short Term Capital Gains.
  • If you invest in Fixed Deposits you will be taxed based on your income-tax slab. Income Tax Overview has details about tax slabs, income from other sources.
  • If you sell the house to gain exemption from tax you can invest the capital gains in another house or invest in capital gain bond. Basics of Capital Gain talks about the various exemption available
  • If you invest in PPF, you get tax exemption on investing under Section 80C, your interest is tax free and on maturity the proceeds are also tax free. So it comes under EEE category.

Three stages of investment and Tax is about Starting with the end in mind, of consider Tax during different stages(Contribution, Accrual, Withdrawal or Maturity) while investing.

Following table tries to capture some of the investment vehicles, the risks associated with them and returns expected and taxation.

Investment channel Types of risks involved Expected Returns
Lending it to institutions

  • Fixed Deposit
  • Recurring Deposit
  • Post office small savings
  • Government Bonds
  • Corporate Bonds
  • Debt Mutual Funds
Interest rate risk – The interest rate, though mostly stable may change with economic change and hence affect your returns
Credit Risk- A small risk of organizations, you lend to, not paying back. This risk is less while lending to the government
Liquidity Risk – These are generally fixed period investments. It is not easy  to withdraw them before maturity. Or if one withdraws one needs to pay a penalty.
From 5% to 10%
Other benefits
1. Relatively stable returns2. Taxed as per income tax slabs . For Debt mutual funds short/long term capital gains are allowed
Buying Shares
-offered directly by companies through an Initial Public Offering (IPO)
-from stock markets
-Investing through mutual funds
Market Risk- the price of stocks is set by the market forces -supply and demand. If there is a high demand for stock, the price will rise. But if there is more supply than demand for the stock, the price will fall. So expect fluctuation in market prices and thus value of your investment from day to day.Capital Risk – Risk of losing all the money you invested , depending upon what stock you invest your money in. Around 0-10%
Other benefits
1. Tax exemption on long term capital gains – Gains from trading stocks over a longer term (more than 1 year) are exempt from income tax.2. Being a part owner, you get to vote for some company decisions.
Buying items of value

  • Commodities like oil, Gold, silver etc
  • Land and real estate
Market Risk – as in case of shares the market price for assets change based on demand-supply gap
Liquidity Risk-It may be difficult to sell off this investment eg. selling land or real estate in parts. Or finding takers for art when you want to sell it.
Returns are variable based on what you invest in, where and when
Other benefits-
1. These investments essentially inflation proof your money. And with prices going up, you can expect to make profits.

Related Articles:

Investing boils down to a person’s needs, How much money the person has, how much does he need after what time, what is the person’s risk taking capability, tax that one needs to pay. Understanding the various investment products help us to find which investment product is suitable to me, to meet my investment objective. Just don’t blindly invest in a product because your friend, family member, agent, TV channel, newspaper says so for a fool and his money are soon parted. What do you say?What do you think before investing?What do you give prime importance to Liquidity,Returns, Risks, Tax?

Disclaimer : This is an information based website, meant for providing assistance to it's readers. We do not hold any responsibility for mis-information or mis-communication.