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| Keep your Capital and Grow it too |
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Rattan Chugh
ExpressMoney
Monday , January 15, 2007 at 1059 IST
You would like to create wealth by investing in equities, but can’t bear to lose your principal. Here’s an investing strategy that meets both objectives
Indians prefer investing in bank deposits, to anywhere else. According to the Reserve Bank of Indian (RBI) annual report for 2005-06, 46.7 per cent of savings of Indian households were
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invested in bank deposits, despite the fact that they barely beat the rate of inflation. By comparison, just 4.9 per cent was allotted to equities, the king of asset classes when it comes to long-term wealth creation. There’s a lot of historical baggage in that pattern of allocation. |
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| Safety only |
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As recently as five years ago, one could earn 12 per cent interest on bank deposits and, for all practical purposes, that investment was absolutely safe and the return assured. It was a good rate and a good post-tax earning. But with average interest rates on bank deposits down to 8 per cent, times have changed. If you are in the highest tax bracket, your interest income will be taxed at 33 per cent, which knocks down your effective return to 5.4 per cent — below the prevailing rate of inflation. |
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In other words, bank deposits help you preserve your money, but not its purchasing power. Since the price of goods (as measured by inflation) has grown more than your money has, your money will buy less in the future. I have spoken to hundreds of investors on the importance of improving the purchasing power of their money. They understand the concept and agree with me, but they don’t extend that thinking to their investment planning, as they find the volatility in the stock market too risky. “My capital should at least be protected at all times,” says Mamta, 29, who has just started investing. |
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Mamta can afford to test the waters for a while, but 40-somethings Amitabh and Aparna Verma, whose approach to equities is similar to that of Mamta, have less time to play with. Both are well-earning professionals, both have managed their cash flows well and regularly aside some of their earnings. |
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With their two sons Shivansh (12 years) and Devansh (10 years) growing, they know large expenses are approaching them. Says Amitabh: “I want to be financially prepared if either of them wants to go abroad for higher studies.” Adds Aparna: “Today, a wedding can cost anywhere from Rs 5-10 lakh.” Much as they understand the need for their savings to beat inflation, they find handling equities too stressful and time consuming. More so now, with the market hovering at an all-time high and showing big swings. Therefore, by default, most of their savings end up as bank deposits. |
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| Safety and growth |
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Even as a financial planner whose ideas they respect, I can’t get them into equities as much as I would like to. So, to start with, I take a middle-of-the-road, best-of-both-worlds approach with them. I suggest two strategies that provide a greater growth kick to their investments, while keeping their portfolio risk within levels they can live with. |
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Growth with protection. I advise them to split their portfolio across debt and equity in a proportion such that, over a designated period, the return earned by the debt portion will provide a strong shield against temporary downturns in the stock market. Say, you have Rs 5 lakh to invest. You invest 70 per cent of this, Rs 3.5 lakh in risk-free debt, earning 8 per cent a year. The balance 30 per cent, Rs 1.5 lakh, is invested in equities.
Over a five-year period, net of taxes, your Rs 3.5 lakh debt portion grows to Rs 4.9 lakh — a gain of Rs 1.4 lakh. Given your need of capital erosion at no cost, you can lose Rs 1.4 lakh of your equity portion, or 96 per cent, and still not suffer any principal erosion on your overall portfolio. The market crashing 96 per cent is a doomsday scenario. With risk odds like that, it’s a good reason why the Vermas should be in equities.
There’s another reason: growth. If the equity portion grows at 25 per cent a year, the 70:30 portfolio will grow to Rs 9.5 lakh — 35 per cent more than the Rs 7.1 lakh a pure debt portfolio will grow to. On a 50:50 portfolio, the percentage downturn in the stock portion to see capital erosion is 41 per cent, which is again rare; meanwhile, the portfolio value, assuming a 25 per cent a year growth in the equity portion, is Rs 11.2 lakh (See table: Get the equity edge...). Since the first big goal for the Vermas is still 10 years away, they should move to a 70:30 debt-equity split, and look to increase the equity exposure in time. |
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Smart debt choices. Bank deposits are among the least tax-efficient options in the debt space. You can easily do better than that. Mutual funds are now regularly launching fixed maturity plans (FMPs), which have a tenure ranging from three months to two years. These schemes invest in ‘AAA’-rated instruments and also attract a much lower rate of tax than bank deposits — capital gain tax of around 11 per cent for maturity of one year, as against 33 per cent on bank deposits. |
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