Anybody who invests in a basket of blue-chip stocks and holds it for 29 years is bound to be a billionaire, right? Not in Japan. With the Nikkei index at the same level as it was in 1983, the value of the investment would be the same as it was 29 years ago. The Japanese aren't alone. Stock indices of the European markets are down to 14-15-year lows. Investors in the US and India are a tad better with benchmark indices at their 2007 levels.
With zero returns after all these years, the cult of long-term investing is almost dead. Yet, financial experts and investment advisers don't tire of preaching that holding stocks for the long term will make you rich. They profer carefully selected data to show how stocks have made mounds of money for investors over different periods of time.
Many more such money myths have been perpetuated by investment professionals. Stocks have the potential to earn high returns, but investors should not wait endlessly to book those profits. Over the next few pages, we have examined seven such money myths, which can work against you in certain situations. For instance, it is not always better to buy a house. A young investor should not allocate too much to an illiquid asset like a house too early in life. Also, if the property market is overheated and interest rates are high, it is better to live on rent.
The mutual fund space is a minefield of myths. Read the reality behind these misconceptions. SIP investments are considered safe and almost a guarantee for better returns. But as we will illustrate, the SIP is just a mode of investment and does not hold out any guarantee of better returns. Buying too many funds with a similar investment mandate only clutters your portfolio without diversifying the risk. Top rated funds are not always the best performing funds.
Another major misconception relates to the Indian investors' obsession with assured returns and tax-free income. This makes them invest in tax-inefficient bank deposits and low-yield life insurance policies. We explain how debt mutual funds will be a better option even though you might have to pay a 10% tax on the income.
Then there is the problem with interest rates on loans. A lay person will obviously choose a loan that comes at the lowest rate of interest, but this can be misleading if you don't check how the rate has been computed. A flat rate of interest may seem low, but actually works out to be costlier than a reducing rate loan.
As the country celebrates its 65th Independence day, it's time for you to break free from the shackles of these ill-conceived notions. ET Wealth will give you all the support you need in your bid for financial emancipation.
Myth 1: Stocks give good returns in the long term
Indian markets have not generated any returns in the past five years.
Financial planners like to parrot the widely held notion that stocks give high returns in the long term. The catch is that 'long term' is not defined. The Indian markets have not generated any returns in the past five years, but some developed markets are worse. Japan's Nikkei, for instance, is at the same level as it was 29 years ago. British, German, French, Spanish and Italian markets are where they were 13-15 years ago. There has been some recovery in the US, but the Dow Jones is still at its 2007 level. So, 'long term' can be extended as per the convenience of the financial adviser. If his clients don't get the desired result in three years, he extends the horizon to five years, or even further to 7-10 years.
Does this mean investors should desert equities and concentrate their investments in the assurance of debt, gold and immoveable property? Certainly not. The journey for the Indian and most other markets has not been flat. There have been bullish phases and bearish periods, each bringing with it an opportunity to book fantastic profits or enter at unbelievably low prices.
Most planners frown upon the small investor's attempts to get in when the prices are low and exit when they are high. "Never try to time the market," they tell him. We agree that you cannot always hope to buy low and sell high. We are not espousing intra-day trading and short-term punting. But booking profits periodically is perhaps the only way to make serious money from a volatile stock market.
Markets tend to go through mood swings. There are periods of extreme pessimism, when market participants behave as if the stock market is going to close down. We witnessed this in 2008-9. Then there are periods of extreme euphoria, when they think stock prices can only go up. We saw this in 2007 and again in 2010. Smart investors who move against the crowd during these extreme situations, buying during a downturn and selling in a rally, make good money
How does one spot these entry and exit points? One simple way is to look at the valuation of the broader market as defined by its PE. We examined the PE and Sensex movement in the past 15 years (see graph below). On the few occasions that it moved below 12 (1998, 2002 and 2008), it offered great buying opportunities. Similarly, when it moved above 24 (2000, 2007 and 2010), these were signals for exiting.
This strategy of buying only below a PE of 12 and selling when it is above 24 requires tons of patience. You may have to sit on cash for a very long time. Also, there is a possibility that you might miss some rallies in the interim. "Since we are the second fastest growing major economy in the world, India doesn't deserve to go below a forward PE of 12," says Chokkalingam C, group CIO, Centrum Wealth.
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Another strategy is for investors to keep building their positions when the PE is ruling at low levels and start exiting when they have reached higher levels. It should not matter whether this happens in a span of five months or five years.
Myth 2: Tax-free options are good investments
A tax-efficient option will yield higher returns than a tax-free one.
Bank deposits and insurance policies are the two most popular investments in India. Almost 45% of the total financial savings of households go into bank deposits, while life insurance accounts for nearly 22%. The concern for most investors is the safety of capital offered by bank deposits and tax-free income offered by insurance policies. They don't realise, however, that bank deposits are not very tax-efficient because interest is fully taxable. In the 30% tax bracket, the post-tax return of a 9% fixed deposit is pared down to 6.3%.
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Insurance policies are no better. They offer tax-free income, but the buyer ends up sacrificing too much. The returns from a traditional endowment or moneyback plan is barely 5.5-6%. Instead, it's better to invest in the PPF, which also offers tax-free income. The current interest rate is 8.8%, but this is linked to the market and could change in the coming years. Also, there is an annual ceiling of Rs 1 lakh on investments in the PPF.
Debt funds offer investor tax efficiency as well as higher returns. After one year, the income is treated as long-term capital gain and taxed at 10%. Yet, small investors account for barely 1-2% of the total investment in debt funds.
Myth 3: Diversification guards against volatility
Buying too many similar mutual funds does not really diversify your investments.
One of the biggest advantages of a mutual fund is that it spreads the risk across a basket of stocks. With 30-40 stocks in the portfolio, an investor can be sure that his fund won't suddenly crash. Though a large number of stocks in a fund's portfolio diversifies the risk, the same cannot be said for an investor who packs his portfolio with too many funds. If he invests in 10 funds that have a similar investment mandate, he is not really diversifying his portfolio. Rather, he is buying the same basket of stocks through 10 different funds.
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To be fair, you cannot fault the funds for following the herd. A fund has to invest in certain stocks if they are in its benchmark index. The large-cap funds that track the Nifty or the Sensex will necessarily invest in index stocks. It's only that the percentage allocation to individual stocks will depend on the fund manager's reading of the market. It is for an investor to look up the fund's investment mandate before he puts in his money. He should avoid duplicating his investments by buying too many similar funds.
For instance, a well-diversified portfolio can be a mix of large-cap, mid-cap and multi-cap schemes. Add a dash of sectoral funds if you want a focused exposure to a particular sector or theme. You will have to do a lot more research than a cursory look at the fund's category and its index. HDFC Equity is categorised as a multi-cap fund and tracks the S&P CNX 500, while HDFC Top 200 is a large- and mid-cap fund with the BSE-200 as its benchmark. But don't invest in more than 6-8 equity funds, because monitoring them will be a challenge. As investment guru Peter Lynch said, too many funds will only 'diworsify' your portfolio.
Myth 4: SIP investments ensure better returns
SIPs are not a guarantee against loss and don't always yield higher returns.
You will not lose money by investing through an SIP.' Mutual fund investors have been sold this story for years. The systematic investment plan is packaged as a panacea to all their investing problems. Don't fall for it. While SIP investors stand a better chance of getting average returns, it is hardly a fool-proof strategy. Neeraj Chauhan, CEO, Financial Mall, says, "SIP is only a mode of investing, a mechanism that helps you average out your costs over a period of time. They do not not guarantee anything."
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When the markets are in a downtrend (see case A), a lump-sum investment at the beginning of the period will lose more than the SIP investment. However, if there is a sustained rally in stock prices, the SIP investor will not gain as much as the lump-sum investor (see case B). The real benefit of the SIP investment kicks in when it is continued over a long period of time and across market cycles (see case C).
However, SIPs involve investing on a predetermined day of the month. This means you lose out if the market slips during the month, offering a good investment opportunity. They are useful because they match the cash flow of the small investor, especially the salaried individual. He allocates a predetermined sum from his monthly income to the investment. A lump-sum investment is not an option he can consider because he doesn't have a large investible surplus. Therefore, the SIP route suits him best.
Another problem associated with SIP investing is that the small investor often loses his nerve when the markets go into a tailspin. Under the SIP route, by investing at different points of time, you get the benefit of cost averaging, wherein you purchase units in the scheme at different NAVs at each interval. This can theoretically allow you to reduce your purchase cost over time. If you stop investing when the markets are going down, you forego the advantage of buying low and averaging out your purchase price. This can be disastrous for your returns.
Ratings are based on past performance and don't guarantee future returns as well.
Investors in mutual funds often use the fund ratings to decide which schemes to choose from among the hundreds available. Though the rankings are based on robust statistical analyses and widely used methods of assessment, many investors read too much into these. This can lead to suboptimal investment decisions.
It's important to note that ratings are based on the past performance of schemes. They do not serve to make a judgement about their future performance. Also, they are based on the percentile score of the schemes. A scheme's performance is not seen in isolation but is rated on the basis of how it performed relative to the other funds in the category. For instance, the top 10% funds are assigned a five-star rating, while the bottom 10% funds are branded one starrers.
Market regulator Sebi has acknowledged how the ratings can be used to misguide investors. In February this year, it banned fund houses from mentioning ratings in their advertisements. Only certain funds, including capital protection funds, which require Sebi-mandated ratings, are allowed to mention these in ads.
Secondly, ratings can change over time. A five-star fund's performance may decline, turning it into a four-star or even a three-star fund. An investor who goes strictly by the rating may then have to rejig his portfolio and shift to a five-star fund. Investors should also note that fund ratings work on a 'one size fits all' rule. They don't tell whether the scheme is suitable for different types of investors. So a multi-cap equity fund with an aggressive mid-cap orientation may have a very high rating, but it will not suit a conservative investor seeking low but stable returns.
A fund's rating, by itself, does not tell you whether it is a good investment or not. So investing in a fund based solely on its rating would be inappropriate. At best, fund ratings can serve as a starting point, says Dhruva Raj Chatterji, senior analyst at Morningstar India. "These fund ratings can be used for initial screening to identify a broader set of funds, but the investor should also look at other factors before choosing a particular fund."
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We looked up the performance of diversified equity funds between September 2007 and August 2011. The results were surprising as well as instructive. Four-star rated funds, on an average, were the best performers during this period. The bigger surprise was that even the average two-star and three-star funds did better than the average five-star fund. However, this is based on the ratings assigned in 2007. They may have changed over the years. A five-star fund in 2007 may not have retained such a high rating or a two-star fund might have risen in rank.
Myth 6: Buying a house is better than renting
Not when real estate prices are overheated and interest rates are high.
Almost everybody dreams of owning a house. No more pushy landlords, poor maintenance and annual rental hikes. Plus, there is always a feeling of uncertainty when the lease is due for renewal. Owning a house frees you from a lot of worries.
Or so you think. Being a home owner has its own sets of problems. It might seem counter-intuitive, but experts say that one should not invest in real estate too early in life. It's a big-ticket investment that ties you down to a location and prevents you from investing in other, perhaps more lucrative, avenues. If your career is on the fast track, anchoring yourself to a particular city might mean forgoing emerging job opportunities in other locations. A big EMI can become an albatross around your neck just when you are finding your feet in the corporate world.
Even older and deep-pocketed buyers need to rethink before they take the plunge. Real estate is an illiquid investment that doesn't allow partial withdrawals. The entry load is very high and disposing of the property can take several weeks, even months. If your job involves a lot of mobility, it may not be a good idea to block your money in immoveable property. If you choose not to sell the property, you will end up servicing an EMI as well as paying rent for the house in the new location. "If one doesn't plan to stay in one location for 4-5 years, I will not suggest he buy a house. Leasing is a better option for him," says Pankaj Kapoor, managing director of real estate research firm Liases Foras.
Buying a house makes sense if property prices are low but are expected to rise soon and capital is cheap. Right now, all three conditions have crosses against them. Property prices are high, especially in some overheated pockets in the metros, and there are indications that the real estate market is likely to stagnate in the coming months. "If you are undecided about the location or the price, renting a property would probably be a better option," says Badal Yagnik, managing director, Chennai & Coimbatore, Jones Lang LaSalle India.
Many home buyers are encouraged by the prospect of not having to pay rent, but keep in mind that bidding rent payments goodbye also means saying hello to home loan EMIs. Home loan interest rates are ruling above 12% right now. Remember that unlike landlords, banks can't be cajoled in case your rent is late. If you miss the EMI, there's a double penalty slapped on you—from the lender as well as your bank.
The rental market, on the other hand, offers a better deal. You can rent a house for a fraction of what you will have to shell out as an EMI. In Noida, a suburb of Delhi, a 2-BHK house can be rented for Rs 15,000-20,000 a month. The price tag of the same property can be as high as Rs 80-90 lakh. If you take a loan of Rs 50 lakh at 12% for 20 years to buy a house, you have to pay an EMI of Rs 55,000.
The case against buying becomes even more compelling if you are an investor, not an end user. The rental yield, which is the annual rent of a property as a percentage of its market price, has steadily dipped in urban areas. In overheated markets, it works out to merely 1-1.25%. In other words, a Rs 1 crore property will fetch a monthly rent of only Rs 8,000-10,000. Experts say that if the rental yield is below 4%, the investment is not worthwhile. This is especially true if the cost of capital is high. What you pay as interest on the loan will neutralise any gain from the property.
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Flat rate of interest may appear low but works out to be costlier than a normal loan.
Planning to buy a car? When you take a loan, make sure you understand how the interest rate on the loan is calculated. Lenders offer loans with different terms and conditions and the lowest interest rate may not always be the best deal.
The flat rate of interest is a widely used trick that creates a financial illusion in the mind of the borrower. The flat rate is arrived at by dividing the total interest paid on the loan by the number of years. It will obviously appear lower than the interest rate calculated on a reducing balance basis. What the borrower does not realise is that he is being charged for the entire loan amount even though the outstanding amount reduces progressively with every EMI. As the graphic shows, a flat rate of 10% is a lot more expensive than a normal reducing rate of 12%.
Another trick is to ask for one or two EMIs in advance. This seemingly innocuous clause pushes up the effective interest cost for the borrower. This is because the actual loan disbursed is reduced by the amount of these advance payments even though the borrower is charged for the full amount. As the graphic shows, a loan at 9% with one advance EMI will actually cost the borrower more than 18%. Similarly, two advance EMIs will push up the effective cost of a three-year loan to a prohibitively high 20%.
In a new trend, some banks are insisting on the borrower parking some money in a fixed deposit with them. The rate of interest offered on these deposits is not very attractive but some borrowers have no choice. They are forced to agree to the terms and conditions laid down by the lender. This also pushes up the effective interest on the borrowing, though the difference is not as significant as in the case of loans with advance EMIs.
It's best to stick to the normal reducing balance calculation when comparing interest rates. To avoid confusion, ask the agent to quote the EMI per Rs 1 lakh. This normalisation of quotes will help you compare the offers of other lenders.
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Home loan borrowers should also watch out for certain misleading tactics used by lenders. They are enticing new borrowers with lower rates, but don't get carried away by these special offers. The catch is that instead of bringing down the base rate, to which all home loans are linked, they just bring down the spread between the base rate and the rate charged to the customer.
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