"Price is what you pay; value is what you get. Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down." - Warren Buffet, American business magnate, investor and philanthropist; considered to be the most successful investor in the world.
When it comes to investing, the first question that comes to mind is “Where should I invest my money?”. If you ask your friends and family for advice, you will probably get at least half a dozen opinions on what is the best place to invest. Our parents and grandparents were part of the generations that considered Gold and Real Estate to be the safest investments which gave stable returns in the long term. In those days, stock markets were perceived as punting grounds where individual investors eventually ended up losing money. Portfolio management and risk diversification were not something the average investors would even think about when planning their finances.
Times have changed and the growth of our economy coupled with a rise of the Indian middle class has led to a surge in new investment options available to retail investors. Financial services companies have launched all kinds of investment products to attract the savings of Indian households. Let's take a look at the most commonly talked about investment products available in the market today.
Bank Fixed Deposits
Bank FDs are one of the least risky investments where you can get 7-10% interest every year. This is a good option for people who have very low risk appetite and who need the money back at a certain time in the near future. One of the biggest drawbacks of FDs is that they are not tax efficient, i.e. the interest you receive is taxable at the tax rate applicable for you. So if you invest in an FD that pays 9% interest and your income falls in the 20% tax bracket, then you would end up with only 7.20% net returns after tax.
Fixed Maturity Plans
FMPs are closed-ended funds that invest in good quality bonds with high credit rating, i.e. those with a very low chance of default. They have a lock-in period usually starting from 90 days up to a few years and give returns based on the interest they receive from the bonds. Returns from FMPs can be slightly higher than FDs, especially in a rising interest rate scenario, and if you invest in those with a lock-in of more than 3 years, then you get the additional benefit of indexation and a possibly lower tax rate.
Bonds and Debentures
Bonds are a form of loan taken by the government or corporates to meet their capital requirements. Bonds are usually issued with a predefined maturity date and promise to pay a fixed interest per year till maturity. The most prominent risk of investing in bonds is default risk, i.e., the risk that the entity that has taken the loan goes bankrupt and is unable to pay the assured interest and initial capital. The risk varies based on the entity that is issuing the bond, and entities that have a higher chance of default usually pay more interest to compensate for the additional risk.
There are different types of bonds available to retail investors. Government bonds are the least risky and hence pay lowest interest rates, followed by public sector companies and then corporate bonds. PSUs also occasionally issue tax-free bonds with significant lock-in periods of 10 to 20 years. They pay slightly lower interest than regular bonds of the same entity but the post-tax returns are usually higher.
Bonds are generally less risky than equities, since if a company goes out of business, then bond holders get paid first with the money generated from the sale of the company's assets. Their main drawback is that interest earned from most bonds is taxable at the investor's applicable tax rate.
Personal Provident Fund
PPF is one of the most common investment vehicles used by retail investors in India. It has very low risk and pays 8-9% tax-free interest per year. The capital invested in a PPF account is also tax deductible under Section 80C. The interest rate is linked to the 10-year government bond yield. The two main drawbacks of the PPF scheme are that the maximum limit on investment amount is 1.5 lakhs per year and you can't withdraw money before the 6th year. After the 6th year, you can withdraw money only once in a financial year and the amount withdrawn can't be more than 50% of the balance in the account at the end of the 4th year.
A mutual fund is a pool of money accumulated from numerous investors and managed by a professional fund manager. Each fund has a specific investment objective which defines where the money can be invested. For instance, a large-cap equity fund will invest only in some of the largest Indian companies by market cap while a sector-specific fund will invest in the best companies of a particular sector such as Pharmaceuticals or IT.
Equity mutual funds held for more than 12 months qualify for full tax exemption on the capital gains, while debt funds are liable for 10% LTCG without indexation, or 20% LTCG with indexation. Both debt and equity funds are tax liable in case they are held for less than 1 year.
Read more about different mutual fund tax treatments.
Mutual funds are a good idea for people looking at long term investment options. They are professionally managed and provide diversification to the investment portfolio. Another benefit of mutual funds is their liquidity. There is no lock-in period which means that funds can be withdrawn at any time. The mutual fund industry is regulated by SEBI to ensure investor safety. One of the main drawbacks of mutual funds is the high amount of management and operational fees they charge. On average, mutual funds can charge anywhere between 1-3% per year for their services. This fee is usually deducted directly from the fund's NAV.
Direct equity is when investors buy shares of companies directly in the stock market. Direct equity is one of the riskier investment options for retail investors. It requires constant monitoring and exhaustive research and analysis which most retail investors do not have the time and resources to do. The main advantage of direct equity is the low transaction costs. If done correctly, then direct equity investments can provide exceptional returns over all other asset classes in the long term.
Unit-linked Insurance Plans
A ULIP is a combination of insurance and investment. The premium you pay while buying a ULIP is distributed between an insurance policy and an investment product consisting of equity and/or debt mutual funds. Investors have the option of selecting the funds based on their investment need and risk appetite. One of the biggest drawbacks of ULIPs is their fee structure. ULIP schemes have a long list of applicable charges, such as administration charges, premium allocation charges, fund switching charges, mortality charges, and policy surrender or withdrawal charges, that are deducted from the premium amount. These charges can turn out to be quite exorbitant when computing net returns on the invested capital.
Equity Linked Saving Schemes
ELSS' provide a decent alternative for people looking at tax-saving investments other than the PPF. These are equity mutual fund investments that are tax-exempt under Section 80C, so you can invest up to 1.5 lakhs per year for tax-saving purposes. The long term capital gains and dividends received from ELSS investments are also tax-free. These schemes are only suitable for investors who have a certain minimum risk appetite since returns are linked to the stock market.
Systematic Investment Plans
An SIP allows investors to incrementally invest a fixed amount of money in a particular scheme or fund at fixed time intervals. SIPs allow investments in a variety of asset classes such as equity, debt and gold. SIPs are useful for salaried people who wish to invest a part of their monthly income or for people who don't want the hassle of choosing when to invest. It also forces investors to maintain discipline by ensuring that a fixed amount is invested at regular intervals.
One of the key drawbacks of SIP investments is their high fee structure. The transaction fees can vary between 0.5% to 1.5% depending upon the amount invested. This is over and above the fees charged by the underlying fund to cover their management and operational costs. So you may end up losing up to 4.5% of your invested capital in fees!
Gold as an asset provides diversification to any investment portfolio due to its negative correlation to stock market returns. There are a number of ways to invest in this commodity, the most common being buying physical gold. One of the other popular ways one can invest in gold is to buy gold-linked ETFs. These are listed funds that invest in gold on behalf of investors. The key benefit of investing in gold ETFs is its high cost efficiency. Owning physical gold comes with a number of problems such as ensuring its purity, cost of storing such a high-value asset, insurance and poor liquidity. ETFs, on the other hand, eliminate most of these risks for the retail investor at a very low cost.
In India, real estate is by far the biggest asset class in terms of total invested capital. Some analysts' estimates suggest that over 70% of total Indian household savings are invested in real estate. The main reason for this is that a number of retail investors consider buying their first home before investing in any other financial assets. Historically, this asset class has also provided exceptional returns and so a large number of people also invest purely for financial gain. But real estate investments come with a number of drawbacks – very high transaction costs, large capital requirement, maintenance and insurance costs and very poor liquidity.