Factors to consider BEFORE investing in Mutual Funds

Mutual Funds offer professional investment management at a low cost. It is not possible for most of us to analyze the companies we invest in or to have enough cash to diversify sufficiently to avoid risk of concentration of our investments in a few shares. In India, Mutual Funds are well regulated and the most transparent financial instrument. You get to see the scheme portfolio every month, get daily net asset values. You know that what value you see on screen is what you get! (You will never get me to like ULIPs even if they reduce costs to near zero)

Below are some things to consider before you invest in a Mutual Fund. I talk here about Equity based mutual funds.

Understand the risk and return associated with investment in equity

Investment in equity has its risks. Risk is the chance that an investment's actual return will be different from what is expected. It also includes the possibility that you will lose a part of your capital / investment. The return is not known to you. This is risk. If you have invested in equity funds during the highs of 2007 -08, you have understood the meaning of risk! Usually, people forget what risk is in an upward trending market. However, as seen in the below graph, investment in equity pay off on the long run. Note my use of the term long run. To make it clear, if you have a horizon of 10 years and more, invest in equity mutual funds. You will build your wealth. See this from this article in the Mint. An investment of Rs. 10000 in Dec 1993 in Franklin India Bluechip has grown to > Rs. 8 Lakhs today!!

Don’t invest at random – Invest only with a goal in mind

This is most important thing in any investment. Most people invest randomly in a Fund or anywhere else. First, someone suggests a hot investment – may a closed end small cap fund and says this will get good returns. Then the amount available is invested. At the end of the term or whenever the money is needed, it is withdrawn at random. There is no method. A simple change is needed. Have a goal for which you intend to make the equity investment. If there is no specific goal, let long term wealth building be the goal. Choose the fund, the period of the SIP or the amount etc. keeping the goal in mind. A clear goal along with the knowledge of risks, return and liquidity associated with you investment will cut out the noise and keep you focused. Read this earlier post of mine. You will also choose the right type of Fund once you have a goal in mind.

Take some time to study the features of the scheme you are investing in.

There are several types of equity funds, Large cap funds – investing only in larger companies, multi-cap investing across all market caps, mid and small cap funds which invest in smaller companies to get the benefit of higher growth. Do read the key features of the scheme. Do not blindly go by the name of the scheme. You can have a look at the previous months’ portfolio of the scheme. It is an advisable practice for investors to understand the investment objective of the mutual fund and know the securities in which the investment will be made. Investors should also know the benchmark against which performance will be measured. This can help compare the performance of the selected fund among the peers. This will also provide insights on the expected return and corresponding risk of the investment.

Note the expense ratio - We generally miss noticing the ‘invisible’ fund charges

In return for offering professional management of your money, mutual funds change a fee which is not noticed by you because it is already reflected in the daily value, the NAV. You thus miss how much you are charged. Do look at fund factsheets and see the expense ratio – the % of the assets managed that are charged. This can alter the nature of your returns significantly in the long term. Direct Plans have lower expense rations and are more profitable for you. If you have knowledge of the product and invest in the Direct Plan of a Mutual Fund, it will make a BIG difference in the long term!

Once you consider all this and have read up about the fund, you are ready to invest. Read this on how to use SIP correctly.

Women and money

Women are recognized to be the best money managers when it comes to managing the household. This is widely recognized. However, in our workshops we found that a lot of women who were earning and contributing to family expenses, had left financial planning and investing decisions to husbands. Reports show that women live longer than men and so statistically will need retirement income for a longer time. This makes financial planning for retirement more important for women. Also, women usually have to leave the workforce to have children, which means they may lose out on growth opportunities, earn less and possibly end up with lower pension benefits, EPF etc. on retirement. We take a look at a few measures that women can take to make a more secure future for themselves.

First, take stock of your own assets – what you own and where it is. Write down all details of the bank deposits in your name, all insurance policies, etc. Next, make a detailed note of all incomes that you earn by way of your salary and expenses and the monthly savings and investible surplus you are left with.

Keep details of husband’s investments: It is imperative to have complete details of the spouse’s bank accounts, FDs, MF investments and demat accounts. Very few women we met in our workshops have details of the husband’s investments.

Demarcate clear boundaries: It's important to do so with your spouse for routine expenses. It will be easier to determine personal monthly expenses and hence monthly savings. It should also be clear as to how liabilities like housing loans etc. are to be paid.

Keep an emergency fund: Do not touch it unless it is a real emergency. Keep emergency funds  to the tune of 3-4 months salary in a separate deposit. When this level is achieved, one can then take the next step towards financial planning.

Goals and investing for goals The next step is to identify financial goals for herself. Goals, typically, include higher education of children, their marriage, buying a car etc. It is extremely important to correctly estimate the sum needed for their fulfillment with the time frame in mind. Also, any likely liabilities should be identified and accounted for, as this affects the quantum of investment substantially. For eg: repayment of a housing loan. In case financial planning seems too overwhelming, it is recommended take the help of a financial planner who can help visualize and plan for long-term financial goals and give investing options.

Insurance: Many women do not consider insurance, both life and health, as priority. However, with rising medical costs it just makes sense to be insured adequately. A working woman contributing to family expenses should have an online term life insurance cover and a health insurance plan along with her husband.

Retirement Planning: Retirement planning has become important in the last two decades. The joint family structure has disintegrated, children work far away from home and are involved in their lives and careers and parents cannot realistically expect their children to bear their financial liability during their retirement years.  Hence, it’s critical for every woman to plan for retirement, the earlier the better. Save and invest as much as you can.

Regular Income when not working or taking a break from work: Even when women take a break from their career, it is a good idea to earn income from working a few hours a day from home. Taking tuitions, teaching a hobby etc are common ways to earn a regular income.

Keep documents securely and in an organised manner: Utmost care should be taken to ensure that all documents should be clear in every respect, especially real estate ownership deeds, so that there is no ambiguity later.

Your financial security is dependent on your attitudes and your willingness to take your financial future into your own hands.

Do you agree with Warren Buffett's views on gold?

Warren Buffett is an investing icon, and when he speaks, investors pay attention. Buffett is well-known for not only his strengths as a businessman, but also for his rather outspoken dislike of gold. The stance is somewhat controversial given the massive popularity of the precious metal especially in India.

Gold bullion and ETFs simply have no place in Warren Buffett’s portfolio. And to hear Buffett tell it, gold should have no place in yours, either. For him, gold is simply useless, is not productive, expensive to store. Some of his sayings on gold are given below.

In 1998, he said - "Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

He echoed these thoughts in a CNBC interview. He was asked, “Where do you think gold will be in five years and should that be a part of value investing?”

“I have no views as to where it will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.  Whereas, you know, Coca-Cola will be making money, and I think Wells Fargo will be making a lot of money and there will be a lot — and it’s a lot — it’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

In October 2010, Warren Buffett said:

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all —  not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

“Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but the gold itself doesn’t produce anything."

He says, “if you own one ounce of gold for an eternity, you will still own one ounce at its end”

So, what do Indians think of gold?

Mr. S Gurumurthy,  a commentator on political and economic affairs and a corporate advisor, in a brilliant article in Oct 2013 has nicely brought out the  importance of gold for Indians who do not just go by the  price trend and return on investment. He says that gold has consistently beaten inflation in India, been a family security to most Indians and a marketable security. He writes:

Modern economists and the Indian people seem to operate on two different paradigms with regard to gold. In the modern West, gold is more a state asset than a private possession. Gold constitutes just three per cent of family wealth there, but a third in India. Western states, socialist or capitalist, expropriated all private gold during the last century. Even the liberal US outlawed private gold in 1936 and built official gold reserve of over 20,000 tonnes by 1950.

Modern economics views gold as an uneconomic, wasteful, private investment. But traditionally, in India, gold has been the preferred asset of the rural masses who hold 70 per cent of the nation’s stocks. Indian gold habits clearly mock at modern economic theories.

Market Oracle, a UK-based market analysis and forecasting online publication, captures the relation between India and gold thus: Indians own 20,000 tonnes of gold worth $1 trillion — almost half of India's GDP. For Indians, gold is not just money or asset; it ensures the financial security and stability of families. It has religious overtones. More than a commodity or money, it is integral to the warp and weft of family life. Investments in gold and jewellery are indistinguishable. Jewellery is the working capital of families; families collateralise it for commercial borrowing.

Some 13 per cent of Indian families, more from rural areas, borrow against gold as collateral; while rural India borrows from the unorganised financial sector, urbanites access bank loans.

Undervalued private financial institutions and the discredited moneylenders are the main sources of finance for the largest employment provider of the country. And the collateral for their loans is invariably gold.

There is no collateral, stocks or real estate, as liquid as gold in India. How can gold, so valuable a security for productive credit, be dismissed in India as a “barbaric relic”?

However, whatever Warren Buffett’s reasons may be, it’s hard to argue against gold’s importance to Indians.

The below chart gives the performance of gold since 1980. 

 Source: WGC

  

CAGR - Jan 1980 till date	2.69%	Hardly any returns over 35 years
CAGR - 1.1.1980 till 30.12.05	0.00%
CAGR - 1.1.2005 till date	11.86%	Huge run up from Aug 2005 to 2011
CAGR - Jan 2005 to Sep 2011	24.64%
CAGR - Sep 2011 till date	-10.97%	Negative returns from end 2011- a retreat from the highs of 2011

It’s hard to tell what the future holds for gold prices. The billionaire investor hasn’t changed his tune on gold, and it’s hard to believe that he will change course anytime soon. Indians dont just love gold. They revere it. Their reverence for gold manifests itself during Danteras and Akshaya Tritiya — the auspicious days for buying gold. The number of lady students in my workshops who will continue to go for gold schemes of jewelers is only proof of the value of gold as a security.

Financial planners always speak of asset allocation and even though prices have fallen from the highs as seen in the above graph, many advisers ask us to maintain an allocation to gold.

So what do you think? Is Buffett simply stuck in his ways, or is he right about gold?

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When do we book profits, sell equity?

Many who had bought equities and invested in equity funds in 2007 -08 and subsequently being disillusioned, have recently sold/redeemed or are confused as to whether to sell now. They have waited for a long time to recover their losses. Now that there is profit, they want to quit. In fact some of them had started redeeming equity funds from Sep. 2013!! Those who entered the market in recent times did not expect such a run-up and do not want to make the mistake of not cashing out in time. Therefore, the question - Do we sell now? Do we book profits?

Unpredictable:

Note, no "expert" can ever really know the top of a bull market - is the Sensex going to be 40000 by 2020 or will it be more?  Markets will ALWAYS remain unpredictable. What worked in the past may not work now in a different situation. In fact, we tend to look at markets that have run up in terms of how much they can fall!!. 

Simple rules may not work:

Many have rules of profit booking, to book out when a certain 'special' level has been reached. Such decisions may all prove incorrect and one may miss a large part of the bull run that happens after exit and leave us regretting. 

Investors also rightly worry about getting greedy. For those burnt badly in a bear market, the predominant thought is caution. Investors recall how they failed to get out at earlier highs and paid heavily for it. They get their daily dose of gyan from TV. The inherent unpredictability of markets make 'expert' recommendations ridiculous at times!!

Since we can never predict when that unknown torpedo will come out of the dark and smash the price of the stocks we hold, the question is: what do we do to build wealth systematically, attain goals and at the same time reduce risks?

Asset allocation and re-balancing as a way to systematically book profits:

Note - An investor, who is booking profits, is actually taking money out of equity, thus reducing exposure to equity. This really is an asset allocation decision. Each time money is moved in and out of equity markets, the investor is not 'booking profits' but re-balancing his money. What is this re-balancing?

First, one has to decide how much money one needs to have in equity based on what returns they need, the risk they can bear and when the funds would be required. Therefore, first, goals and the period should be very clear. An investor who plans to fund his own retirement after 20 years may want a higher proportion of his money in equities to allow time for growth and to beat inflation; similarly to fund your child's education 12-15 years later, you may decide to have a higher allocation in equity to beat inflation in education costs.

Based on our risk profile and goals we decide as to how much to invest in equity and how much in debt. In equity we include shares, equity mutual funds and we include fixed deposits, NCDs, bond funds, PPF in debt. (Investors can even include other asset classes like gold etc)

Let us say we have deliberately decided to have a 60-40 equity-debt ratio allocation. This allocation ratio is our strategic allocation, and is the most crucial decision one can make. Rebalancing is the deliberate, periodic realigning of a portfolio of investments to bring it back to the original target asset allocation. This way we systematically capture returns "book profits" - and reduce unintended risks created by over-exposure to one category. We do not bother about timing markets or worry too much on which way the markets would go. So, when markets go up and our equity valuation rises, we are automatically "booking profits" to bring back the ratio to 60-40 and reducing the risk of higher exposure to equity. Irrespective of where the market is, 60% of our money needs to be in equities..

An example would help us understand re-balancing:

Let us say an investor has decided to have a 60-40 ratio and has invested Rs. 60000 in Equity Mutual Funds and Rs. 40000.00 in Debt – comprising of FDs, Debt Funds etc. on January 01, 2015. 

Assuming the debt portion is worth 44000.00 on Dec 31, 2015. Let us assume that the market was good and the equity portion has gone up to 120000.00. This would mean that the equity to debt ratio in the portfolio is 73-27 , which would mean a higher exposure(73%) to risky equity. Now after taking stock, the investor should reduce exposure in equity (redeem funds - sell equity, in other words, book profits) and invest in debt to bring back the ratio to 60-40.

If however, equity component has gone down, then one should reduce debt and invest in equity to bring the balance back. 

This way not only you know how much to 'book' but you don't really care where the market is when you book profits. Following this gives you a freedom and takes out the confusion from investing.  Moreover, your focus is not on what others are doing, but on your own portfolio. 

So how does one go about this?

For a start 

• Evaluate your current portfolio
• Decide the allocation as per your risk-taking ability. You may take assistance in this from a financial planner. 
• It will be difficult to make an exact ratio and you may allow yourself a small gap -for e.g. equity may go between 57% to 63%
• The equity allocation can be increased to reach the desired level slowly, by means of SIPs. 
• Follow a policy of checking and re-balancing every 6 months - even a yearly review will be fine i.e moving assets to maintain the proportion

Re-balancing forces you to base your investment decisions on a simple, objective standard - Do I now own more of an asset than my plan call for.

Follow this and be relatively free from the emotional upheavals that market movements cause.

For those who still want to take a call - Look for potential downside

Those who still need to take a call may check market valuations (read this post) and see where the market stands today. The point to note is to look for how much downside could be there. 

When one sees too many IPOs at super high prices and  when every one and his uncle is bullish is a sure signal that it may be time to book some profits to reduce the equity proportion in your portfolio. This approach means looking for signs of a crack up. 

Market emotions cycle

Note: Investors can take the assistance of a financial planner to come to asset-allocation decisions.

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How are markets valued today - Nifty PE and PB

The Nifty is above 8100 and the Sensex above 27100. Stock market indices are at all time highs.

So, where are we in terms of valuations when compared to previous highs. Two important ratios used to evaluate a share are the PE Ratio - (Price-earning ratio) and the P/B Ratio (price-to-book ratio). When evaluating the market, we take the PE and PB of an entire index to see its valuation and I have taken the PE and PB of the Nifty form 1.9.2006 and plotted on the below graph.

This chart shows the PE and PB of the Nifty from 1.9.06. We are far away from the high valuations of Jan 2008 and Oct. 2010. The Nifty PE was 28.29 on 8.1.2008 and 25.72 on 6.10.2010. The price to book was at a high of 6.55 on  8.1.2008 and 3.97 on 2.11.2010.

Today, we are at a PE of 21.22 and PB of 3.52 for the Nifty.

Source: http://www.nseindia.com/

Nifty PE and PB

Well we still have some way to go before valuations become expensive. One thing to note - as the economy revives and profits grows,  predictions of various brokerages may still turn out correct! 

SIP being the best way to invest for the long term,  here's an earlier post on how to invest using SIP properly!

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