How to choose a financial product?

1. How to choose a Financial Product?
2. How to compare Financial Products?
3. Could I time the entry/exit of my investments?

Let us understand each of these issues that investors face in a 3-part series..

Choosing a Financial Product

Today there are hundreds of financial products to choose from the market. They range from simple fixed deposits to complicated ULIPs. Then we have health insurance plans with all kinds of riders (flexible or restrictive), loan products (home, vehicle, personal) & lastly, the Capital market products – Mutual Funds, Equities & Derivatives.

Hema, a 23 year old designer, has been working only for 2 years. However, she seems to have already bought 3 endowment policies with a total premium of Rs.25,000 p.a. She neither has any idea on the life cover received nor on the adequacy of cover. She was told she would get Rs.10-12Lacs after 25 years (this is called the future value), so she thought it is not a bad idea to take up the policy.

Even before she realized what she had bought, her family’s well-wisher was selling her more policies each year. When the premium burden increased, she started asking some questions such as what are the returns from the policy and whether she could exit half way. But the only answers Hema received were the policies would help her save tax and give her good returns after 25 years.

Understand by reviewing your Insurance Policies

Upon reviewing her policies, I noticed that Hema’s life cover was barely Rs.6L (all 3 plans combined) and the illustrated approximate returns were only Rs.2.5L, inflation-adjusted in today’s money value, giving her 3-5% p.a returns. Also there is a bonus part in every policy which is subject to market conditions, it is variable and not guaranteed – it is only illustrative, putting it in the same league as mutual funds.

When she was shown the math behind her plans, she was shocked and confused as to whether to continue with the policies for the remaining 23 years. But the review helped her understand that insurance is not investment. She made a prudent choice to discontinue her endowment policies and bought other pure term plans that offered her higher life cover for Rs.1 crore at a much lower premium. This move also allowed her to invest the Rs.25,000 in PPF (an alternate) and reap additional returns.

So, why do we buy insurance?

There is widespread belief among us that the sum assured in a policy means “premiums paid are returned with assurance“. In a way it is ingrained in our minds that insurance is some form of a “capital-protected” investment compared to other financial products such as mutual funds or equities, which come with a tag-line “Mutual Funds are subject to Market Risks”. But the fact is both insurance companies & fund houses invest in the same bonds & stocks of the Indian capital market and hence they both face the same risks.

What should an investor do?

Investors need to ask certain basic questions prior to parting their money and assess the suitability of the product, its risk, the time horizon of investment & returns.

Ask these questions and seek to understand the financial instruments. Invest your money only if you receive simple, straight forward and reasonable answers for the above questions. If you exit an insurance policy, you get only 30% of all premiums paid, compared to losing 30% in a financial crisis in an equity mutual fund. So, like Hema, seek to understand the financial products before parting your hard earned money.

In the next article, we shall examine the next challenge that investors face – how to compare different financial products?