Money Smart Mom: Making informed investment decisions

FDs or mutual funds? Gold or real estate? ULIPs or a PPF account? Feeling lost with the plethora of investment products available? Our expert helps you find your way through the maze of options.

By Satish Kantheti and Aruna Raghuram

Money Smart Mom: Making informed investment decisions

This is the third of three articles in the 'Money Smart Mom' Series. Find the first article here and the second article here.

ParentCircle asked Satish Kantheti, director in the Hyderabad headquartered financial services company Zen Money, to focus his expert eye on the pros and cons of various investment options. Read on for some very useful and insightful information.

Q1. What are the types of investment avenues available today?
There are various investment avenues one can look at while saving for financial goals. But one should consider investing in products that match your own risk profile, time frame, as well as returns that suit your investment goals. In general, investments that carry high risk have the potential to generate high inflation-adjusted returns in the long run compared to other asset classes. Some investments come with low risk and give low returns.
There are four categories of investment options that you can add to your portfolio:

  1. Income generating fixed income products: bank fixed deposits, Public Provident Fund (PPF), government bonds
  2. Value preserving: Gold and precious metals
  3. Protection oriented: Employee schemes (EPF) and insurance-related schemes (ULIPs)
  4. Growth generating: Shares/equity mutual funds, real estate

Q2. What are the primary considerations while designing a portfolio?
The main purpose of investment is to meet your financial goals. An investment portfolio should be aligned to one’s goals and risk profile. A few factors that need to be considered while designing your investment portfolio are:

  • Before starting to invest, be clear about the objective for investing, your time frame and also the expected returns to meet the goals
  • Every investment product involves some risk, so consider your risk-taking capacity and willingness. Not every asset is suitable for every investor
  • Age is one of the factors while designing a portfolio. Being young has advantages. If you are young, you can wait for a longer time and can get into investments that are riskier but can potentially earn higher returns
  • Asset allocation plays a key role in determining a portfolio’s overall risk and return. Understand and analyse various financial products before adding them to your portfolio. Select instruments that are suitable for you as per your investment profile
  • Diversification across asset classes is one of the basic building blocks of a good portfolio as it reduces risk and helps to maximize returns. There should be a balance between the amount invested in high-risk and low-risk options. A well-balanced portfolio helps investors balance risks and returns
  • Investing regularly, and in a disciplined manner, can help in constructing a healthy portfolio. If you have a constant income, you should try to invest in your portfolio as frequently as possible
  • Before selecting an investment option, know the tax benefits or implications of that particular product. Invest in assets where you can save taxes and decrease your taxable income, A portfolio of investments that are tax-free will help grow your wealth faster in the long run than investments that are taxable
  • Hold some portion of assets in cash while constructing a portfolio. This way you can rebalance the portfolio in case of adverse market movements and earn better returns.

Q3. How can one balance the trade-off between risk and return?
The risk-reward trade-off is the balance that an investor has to achieve between the risk involved in an investment and its potential returns. The first important thing is to determine the level of risk you are ready to take, and then select the appropriate instruments that ensures your goals are not only met in time, but are also in accordance to your risk profile. Avoid taking unnecessary risks by selecting wrong products while building your investment portfolio. Understanding the risks involved in various investments, minimising them, and generating higher returns is the key to success in investment.

Q4. What are the pros and cons of fixed deposits, PPF accounts and government bonds?
1. Bank Fixed Deposits (FDs):
A Bank FD is a traditional, safe, extremely low-risk investment option.
Pros:

  • Guaranteed returns and safety of principal amount
  • Flexibility on the tenure and periodicity of interest payments
  • High liquidity – there is an option to make a withdrawal as per requirement. The FD can also be pledged for availing a loan

Cons:

  • FDs are tax inefficient - interest income from FDs is fully taxable as per your applicable income tax slab
  • Low rate of return – post-tax return from FDs does not even beat inflation

2. Public Provident Fund (PPF): PPF is one of the most popular long-term saving schemes and suits investors looking for risk-free returns.
Pros:

  • One of the tax-saving investments available for deductions U/Sec 80C. Contributions to PPF are tax deductible up to Rs 1.5 lakh p.a. If you invest Rs 1.5 lakh in PPF, Rs. 1.5 lakh will be reduced from your taxable income
  • Minimum investment of Rs 500 only per year to keep the account alive
  • Interest and maturity proceeds are tax-free
  • Provides option for partial withdrawal and taking of loans
  • Easy to open an account in a bank, designated post office, or online

Cons:

  • Lock-in period of 15 years
  • There are some rigid rules. You cannot withdraw from PPF until the completion of 7 years. The account cannot be closed until maturity
  • Returns may not be able to beat inflation
  • Only one account allowed for every citizen and no joint accounts allowed

3. Tax-free bonds: Tax-free bonds are long-term in nature, issued for a period of 10, 20 and 25 years, by government owned companies like NHAI, PFC, IRFC, HUDCO and REC. They are more suitable than FDs for high tax bracket individuals as the interest earned is completely exempt from tax.
Pros:

  • These bonds carry low risk as they are fully secured and most of them are AAA rated by credit rating agencies
  • Assured returns as the fixed coupon/interest rate is paid quarterly/annually
  • As these bonds are listed on stock exchanges and can be sold, they offer an exit route to investors

Cons:

  • No tax benefit on the investment amount
  • Capital gains from the sale of these bonds in the secondary market are taxed on a short-term or long-term basis
  • Demat account is compulsory to trade in these bonds
  • Liquidity is low in tax-free bonds as you cannot withdraw money before the maturity date
  • Interest rate depends on the yield of government securities prevailing around the time of issuance of the bonds
  • These bonds are not available at all times

Q5. What about investing in the National Pension Scheme (NPS)?
NPS is a government-backed, low-cost retirement benefit scheme introduced to provide regular income post retirement for all citizens of India. Individuals between the age of 18-65 years are eligible to subscribe to NPS.
Pros:

  • Investment is handled by professional fund managers and low fund management charges result in higher yield in the long run
  • The minimal annual contribution is Rs 1000 p.a.
  • Can benefit from diversification with a single investment. NPS allows you to invest in equity as well as debt market
  • Tax Exemption up to Rs 2 lakh for subscription in NPS (Rs 1.5 lakh U/Sec 80 C and Rs 50,000 U/Sec 80CCD)
  • Also, 60% of corpus eligible for withdrawal on attaining the age of 60 years is tax free

Cons:

  • Investment in NPS does not guarantee return as it is subject to fund performance over a period of time
  • No withdrawals till maturity
  • Fund allocation to equity restricted to a maximum of 75% of your investment
  • A minimum of 40% of the maturity proceeds (which is taxable) has to be used to purchase annuity plans to get regular income. These plans offer poor returns which may fall behind the inflation rate

Q6. What is the advantage of investing in gold and real estate?
Gold:
It is one of the oldest and most traditional investment options. You can buy physical gold (bars, coins and jewellery) or gold ETFs (exchange traded funds) and sovereign gold bonds.
Pros:

  • Hedge against market volatility as it is inversely correlated with the stock market and currencies
  • Has the potential to give inflation-beating returns
  • Gold holds an inherent value over a period of time
  • Easy and convenient way to diversify the investment portfolio

Cons:

  • Gold investment as an asset fails to give any regular income
  • Risks of theft associated with physical gold
  • High storage cost (of hiring bank lockers)
  • Gold prices can be volatile on a short-term basis as they depend on international market prices
  • Holding physical gold in the form of jewellery has the risk of depreciation. Sale amount depends on level of gold purity and making charges

Real Estate: Every one’s dream is to have a home regardless of the cyclical nature of real estate prices. Real estate investment can be good long-term investment if the value increases over time.
Pros:

  • Historically, real estate rates appreciate substantially
  • Can be used for self-occupation
  • Regular income through rent
  • Can be mortgaged during financial difficulties
  • Hedge against inflation

Cons:

  • Low liquidity
  • Large capital requirement
  • Can result in postponement of other goals
  • Mis-selling can lead to capital loss

Q7. What about investing in equity? How risky is it?
Equity is an asset class that has the potential to significantly increase in value over time if we invest wisely. Though considered risky, investing in equity is the best way to build wealth or to meet long-term financial goals. Staying invested in equity for a long term will reduce the impact of market risk and can generate superior risk-adjusted returns.
Pros:

  • Provides liquidity as shares can be traded on exchanges
  • Potential to realise high returns and capital appreciation over the long term
  • Ability to beat inflation in the long run
  • Additional income from dividends and benefits like bonus issues/buybacks etc.
  • Advantage of diversification by investing in different sectors/stocks
  • Get ownership in company for up to the amount invested
  • Equities are also tax efficient compared to other investment avenues
  • The equity market is well regulated by SEBI (Securities and Exchange Board of India)
  • You can participate in corporate India’s growth

Cons:

  • It is a high-risk investment option as investment in equities or stocks are subject to market risk
  • No assured returns. Stock market volatility can lead to a substantial loss of investment
  • Requires large amount of capital to invest in a diversified portfolio
  • You need to do considerable research and be knowledgeable

Q8. What are the advantages of investing in mutual funds?
A mutual fund is an investment product that pools money from investors and invests it in a wide variety of stocks, bonds, and other instruments. In fact, investing in mutual funds is an indirect investment in the market. Mutual funds are ideal for people who don’t have the time to manage their portfolios as these funds are professionally managed. Investing in a well-diversified portfolio of mutual funds would create wealth for investors in the long run.
Mutual funds can be equity mutual funds and debt mutual funds. Equity mutual funds, which invest in stocks, are riskier. Another differentiation is between close-ended (with a lock-in period) and open-ended funds.
1. Equity mutual funds
As they invest in a variety of market-linked instruments, they have the potential to generate high returns over the long term.
Pros:

  • If you don’t want to/can’t make a one-time lumpsum investment, you can start a systematic investment plan (SIP) in a mutual fund with as low as Rs 500 per month. SIPs bring discipline in savings and create wealth in the long run
  • Ability to invest and redeem with relative ease, with minimum exit load
  • Managed by professional fund managers who track the fund performance on a regular basis to ensure that they deliver high returns to the investors
  • You can minimise risk by diversification
  • High transparency of information and well regulated
  • Flexibility to switch between the funds at little or no charge
  • Investment in ELSS (equity-linked saving scheme) mutual funds of up to Rs 1.5 lakh is eligible for tax deduction U/Sec 80C. ELSS funds come with a lock-in period of three years

Cons:

  • As equity mutual funds invest in diversified financial instruments, they are exposed to different types of risk like market risk, concentration risk, interest rate risk, liquidity risk and credit risk
  • In addition, there is the fund manager risk – returns are largely dependent on a fund manager's ability to generate returns
  • Returns are not guaranteed

2. Debt Mutual Funds: Debt mutual funds invest in fixed-income generating securities like corporate bonds, government securities, treasury bills, commercial paper and other money market instruments. These funds are ideal for investors who want steady returns with low risk.
Pros:

  • Debt mutual funds are more liquid than a bank FD which involves a lock-in period and some penalty on premature withdrawal
  • They help investors get capital appreciation from bond price rise in a falling interest rate scenario
  • Debt funds are tax-efficient if the holding period is more than three years as then capital gains from debt funds will be treated as long-term and will be taxed at 20% after indexation.
  • Buying and selling debt mutual fund units involves low transactional costs
  • Debt mutual funds provide unique stability to the investment portfolio

Cons:

  • Debt funds carry interest rate risks, market risks and liquidity risks
  • They are not guaranteed and there is no assurance of capital safety
  • The returns or quality of instruments depends on the fund manager and the investment philosophy of the scheme

Q9. Should one invest in ULIPs (Unit Linked Insurance Plans)?
A ULIP is a hybrid product, that comes with a combination of protection and saving. It not only provides life insurance but also helps you save/invest in various market-linked instruments to meet long-term goals.
Pros:

  • Withdrawals are tax-free – no Long-Term Capital Gain (LTCG) tax on returns received from ULIPs
  • ULIP premium is eligible for tax deduction U/Sec 80C
  • Flexibility to choose the funds of choice based on risk tolerance and financial objectives
  • Free switching (up to a limit) between funds and asset classes based on changing investor needs

Cons:

  • Liquidity constraint as the money can’t be withdrawn before the lock-in period of 5 years
  • Insurance cost is higher in ULIPs
  • High volatility in markets may result in low returns
  • Chances of mis-selling of ULIPs to investors by insurance providers

Q10. When should one start post-retirement planning?
To have a regular flow of money after retirement that will enable you to manage the increased expenses without compromising lifestyle, retirement planning is a must. You should start planning for your retirement at an early age i.e. when you start earning. Since retirement is a long-term goal, it is important to understand the impact of inflation on your financial goals and choose the assets that provide returns that beat the inflation rate. Before planning, have a clear idea of the amount needed monthly post retirement.
If you start at an early age you can invest in a more aggressive investment options where rewards could be greater. This way, you will reach your goals early. If you save and invest a considerable amount in the young days, due to the power of compounding, you will have a huge corpus saved for your retirement days.
In sum, investment is about making wise, smart choices. And, these choices should ensure a healthy balance between risk and return.

In a nutshell

  • Before investing in a product, assess your risk profile, time frame, returns and tax implications
  • In general, investments that carry high risk have the potential to generate high inflation-adjusted returns in the long run
  • Each investment product has pros and cons. Not every asset is suitable for every investor.

What you could do right away…

  • As you are earning, start planning for retirement right away
  • Check if your portfolio is diversified enough to balance market risks
  • Ensure you invest regularly and in a disciplined manner. Going for a SIP is a good way to do this

About the author:
Written by Aruna Raghuram on 30 September 2019.
Raghuram is a journalist and has worked with various newspapers, writing and editing, for two decades. She has also worked for six years with a consumer rights NGO. At the time of writing this article, she was a consultant with ParentCircle.

About the expert:
Reviewed by Satish Kantheti on 30 September 2019.
He has an MBA in finance and is a CFA (chartered financial analyst) as well. With an experience of nearly 19 years, he is actively involved in investor education initiatives.

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