Understanding the time value of money

You must be familiar with financial products that claim you just need to invest a sum for a certain period and then see it double at the end of the term. While it is easy to think you have earned a return of 50%, it is not so. This is because your money gets compounded each year at a certain percentage of return.

E.g. if you are investing 10,000 for 10 years and are getting back 30,000 at the end of the term, your effective rate is 11.61% compounded annually.

This concept is known as the time value of money.

It says that money available currently is more valuable than the equivalent sum later on because of its earning potential.

So the Rs 30,000 available with you presently is far more than Rs 30,000 available to you in the future.

Why is this important? Whenever you have money, you can either choose to spend it or invest it. If you opt to invest it, you should ensure you earn much more than its present value. This is why it is important to keep your investments for long-term. This will help you earn better returns.

ULIP war – Who loses?

Recently ULIPs were in the news when SEBI had directed 14 insurance companies not to issue any new ULIPs. SEBI contended that despite being an insurance product, ULIP had a high proportion of investment and thus should be regulated by SEBI. However in reality IRDA regulates the insurance products including ULIPs.

The case went to the court and the government had to step in and hand over the jurisdiction of ULIPs to IRDA. But in this war, it is ultimately you the customer has lost. Wondering why? Here is why.

This is because mutual funds and ULIPs do not have level playing field. While mutual funds are not allowed o pay upfront commission to its agents, ULIP agents can pay commission as high as 40% to its agents. As a result, many financial advisors tend to push ULIPs on their unsuspecting clients. Now remember, this commission comes from your investment.

The drawback of ULIP is that you need to keep your investment for at least 10 years to recover this upfront commission. This despite what many insurance agents tell you that you can keep on investing only for 3 years. Also the insurance cover is very low than what you would get for half the investment had you opted for term plan.

Moreover returns from ULIPs are not guaranteed as it is a market-linked product. Thus looking at drawbacks of ULIPs it is advisable to stay away from ULIPs. But with IRDA winning the battle against SEBI, it is the customer who has lost.

Is PMS for you?

Want to invest in equities? Then you can invest in them either directly or indirectly. When it comes to indirect investment, you have two options: mutual funds and portfolio management service (PMS). Let us understand more about PMS and see if it right for you.

What is PMS? PMS is a customized investment service offered to big investors, who have a lot of money to invest. There is a fund manager to look after each PMS account. You give him a restricted power of attorney to invest money on your behalf. The investment is made on your behalf after taking into account your investment objectives, time frame and risk appetite. So a portfolio of a 28 year old with a small child, looking to build corpus for his child’s education is quite different from the portfolio of a 55 year old man looking to build retirement corpus.

Pros: Here are some of the advantages of PMS.

• Customized asset allocation: The portfolio each investor gets is determined by his risk tolerance level, duration for which you intend to remain invested and why you want to invest. E.g. if you want to invest your money in order to purchase a house within 2 years, your asset allocation will comprise mostly of debt instruments. But if you are planning to invest for your 2 year daughter’s marriage, you are most likely to get equity recommendations.
• 24×7 access: Most PMS service providers let you view your account online. You can analyze the performance of your investments and get information on your capital gains, booked/un-booked gains, updated value of your investments etc.
• Tax efficiency: The fund managers manage your investments in such a way so as to reduce your tax liability.
• Qualified fund managers: Most PMS services are run by professional fund managers who are experts. Thus you can rest assured that your money is in safe hands.
• Reduces your responsibility: You don’t have to spend time looking after your portfolio. Your fund manager is there to look after it and take decisions that will benefit you.

Cons: PMS also has its own share of drawbacks.

• Inability to compare the performance of fund manager: As most of the PMS services are not regulated, it is difficult for you to tell which fund manager has given you the best performance.
• Expensive: PMS managers charge a flat fee + a certain percentage of profits made by your investments. Usually it is the profits that make up the larger portion of the fund manager’s charges. This can work out to be expensive for you in long run.
• Not suitable for expert investors: If you have time and have good investment experience, then PMS are not for you. However for that you need to be emotionally detached. If not, then PMS is your best bet.

Is it for me?: Yes, if you have lot of money and not able to detach yourself emotionally from your investments and have no time to research before investing.

Why insurance is not a good investment option?

“Invest Rs. 2000 a month and get Rs 5 lakhs after 5 years.” “Give a better future to your child by investing in our insurance plans.” These and other similar advertisements bombard us everyday. The basic aim of these ads is to market insurance plans as investment vehicles. But is it true? Do insurance plans really make good investment options?

To answer this question, first let us understand the main objective of insurance. The primary aim of insurance is to protect you and your near and dear ones against any unforeseen calamities. Let’s say, you have met with an accident, due to which you are unable to work. It will affect your income and you and your family will suffer financial hardships. But if you have an insurance cover, you can claim compensation, that will help you ride through the tough time.

Now when you look at insurance as an investment option, a portion of the premium you pay towards your life cover is invested. Depending on your risk profile, you can choose to invest in equities or debt. As a result, the life cover you get is significantly reduced. Also to manage your investments, the insurance company has to hire expert fund managers, which cost money. The fees for their charges are deducted from the value of your investment. Consequently, the value of your investment decreases.

Moreover the charges and the portfolios of these plans differ vastly amongst different insurance companies. This makes it difficult to compare the returns of these plans. Hence insurance + investment combo doesn’t make smart investment decision. Instead, it is better to take both of them separately. Remember the key to successful investment is disciplined and consistent approach.

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