Where to invest excess money?

Knowledge, Discipline & Time are the 3 vertices of an investment triangle. Once an investor gains understanding of these key areas, investing excess money becomes an enjoyable process.

Knowledge is foremost

As investors, we need to be aware of the various financial products available in the market. Without first hand knowledge of various products, it is easy to fall prey to quick sales tricks and part our money to unsuitable products. Let us take the case of Anand, a manager in a private sector firm. In 2017, when he received his bonus, his relationship manager called him and recommended him to invest in Arbitrage funds (AF).

The primary reason cited to him being good returns and no long term tax since arbitrage fund is treated at par with equity funds. It was further explained to him that a portion of the arbitrage funds would be invested in derivatives to cover any fall in stocks held by the fund. Anand was convinced and invested his entire bonus in one such arbitrage fund. However, Anand is very disappointed that his 6.7% returns from the fund has been lower than liquid funds (7.2%).

Seek knowledge..

When treading in unknown waters, it is better to familiarize with the new product by reading or seeking expert opinion. Had Anand sought help from experts or advisors on arbitrage funds, he would have come to understand that Arbitrage Funds (AF) is a type of mutual fund that uses the price differential in the cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset. AFs buys stocks in the equity market and simultaneously sells it in the derivatives market. The price differential between equity market & derivatives market is used to generate returns for the fund.

Many funds in this category were launched in 2014 when the bull market in sensex had just began, which is a ripe platform for AFs to perform. It was also in the same year that the holding period for FMPs (Fixed Maturity Plans) to qualify as long term was revised from 12 to 36 months. This led investors to search for tax free avenues with a maximum of 12 month holding period, resulting in a shift from debt to equity oriented Arbitrage funds.

Is a product suited to retail investors?

AFs seems to be designed for businesses to park their idle cash and enjoy tax-free returns in a short time (1 year). It is also suitable to stock traders familiar with derivatives. Inflows into AFs have particularly spiked post-demonetization. And its story sold well with a retail investor who is obsessed with tax savings.

Gaining knowledge on Afs reveals that there are three main issues with AFs.

1. From a risk profile perspective, under the premise of tax savings, this fund shifts an investor from low risk to high risk (debt to equity).
2. From a product perspective, if an investor is ready to take on equities, better alternatives are available in large-cap & multi-cap equity funds.
3. From arbitrage perspective, when more money chases fewer arbitrage opportunities, returns will be zero.

Also, the risk of the tax benefit of AFs being taken away became real in 2018 budget. Overall, AFs are not a good fit for retail investors who have custom-built their portfolio to align with their financial goals. A well-planned portfolio worth Rs.30 Lacs or even higher would be very tax efficient with proper asset allocation, eliminating the need for a retail investor to chase unsuitable tax saving funds such as Arbitrage funds.

How knowledge helps an investor?

Knowledge helps dispel myth & fear and helps in understanding a product. Without this understanding, if you chase returns, you will end up with a portfolio full of irrelevant products which may not grow adequately to fund your financial goals. Once you acquire knowledge, you may or may not become comfortable with a product – but you would be in a much better position to make an informed decision, which is key to an investor.

Discipline is easy when imposed

Discipline in investing is an essential ingredient to successful investing. When we stay invested in a right asset over a longer duration, it certainly pays off. Let us take Suresh, a teacher, who has a home loan EMI to pay for 15 years. Only if he pays his monthly EMIs regularly without fail, he could own the property at the end of the loan tenure. Paying a monthly EMI is a huge commitment and requires discipline on part of the investor.

Similarly, take Sara, a lawyer, who pays the premium for her parent’s health insurance policy. Only if she pays the annual premium in a disciplined manner, her parents would be able to avail the hospitalization benefits. Most of us diligently pay our periodic payments in a disciplined way, like Suresh & Sara, so as to enjoy the asset(s) or facilities as required.

In both these cases, discipline is imposed on them by a third party (Bank or Insurance company) to make payments on a regular basis.

And discipline is hard when voluntary

Now, take Kathir, an accountant, who invests Rs.25,000 per month in mutual funds via SIPs. Due to a recent market correction, his existing portfolio is down by 12% and so he is considering stopping his SIP. If he indeed stops his SIP, he has nothing to lose immediately, although he may hinder his own long term wealth building.

In comparison, if Suresh or Sara stop their periodic payments, they stand to lose their house & hospitalization benefit right away. However, this is not the case with Kathir, why? Because SIP is voluntary, no one is imposing this periodic payment on him. This makes it all the more challenging for him to stay invested in a disciplined way with his SIPs.

How discipline helps an investor?

At this juncture, it is important for Kathir to keep his focus on his long-term goals. If he wants to fulfill his financial goals in future, he must continue with his SIPs regardless of market movements. If he lets short-term market volatility dictate his investing approach, he may not have sufficient money to fulfill his future liabilities.

Time is money

To understand the power of time, let us consider an important life goal of Sara (age 25) & Kathir (age 35). They both have a goal to retire at 55 years of age and would like to get a retirement income of Rs.50,000 per month in today’s terms (present value). To attain their respective retirement goals, Sara needs to save Rs.16000 p.m while Kathir will have to save Rs.30000 p.m. This is because Sara being 10 years younger to Kathir, she has 30 years left to retire.m while Kathir has only 20 years to retire. Even though the time difference is only 10 years, the amount required of Kathir to save doubles, as he has lesser time to put his money to work.

Young people like Sara may not have Rs16000 disposable income at age 25, an alternate would be to start even with a smaller amount such as Rs.8000 and increase it by 10-15% every year to attain the same goal.

Similarly, if Kathir wants to fund his daughter’s higher education expense of say Rs.10 Lacs (in today’s cost), he needs to start investing when his daughter is 10 years old. In this case, he might have to save only Rs.15000 p.m. If he postpones saving for this goal until she is in class 9 or 10, then he might have to shell out Rs.35000 p.m or higher because he does not have the time to let his money work & multiply for him.

How Time helps an investor?

In essence, time is money. You do not need to hit a jackpot or become a millionaire to achieve your financial goals. The secret is, even with little money, you may be able to fulfill all your life goals, provided you have the knowledge, discipline and time on your side!