Financial products and the circle of wealth

One of the reasons that people find buying financial products tough is that
there is no connect between the product and what it will do. A car gets you
around the city. A washing machine, well, washes clothes. And a laptop
allows me to write this piece.

But what will that mutual fund do for you? Or this insurance policy? Look at
the financial products you have in your portfolio and answer this question:
What is the role of each of these products in your life? Why did you buy it
and what will it do for your financial life? I have been asking this question at
my workshops for a while now and the overwhelming lack of an answer and
the sheer confusion about financial products and their function in our lives
promoted me to design a system that will attempt some answers.

Called Dhan Chakra—the circle of wealth, the basic concept forms the heart
of the book by the same name that I am working on. I found that the Dhan
Chakra concept works across income, social, gender, geographical and other
divides and has proved to be a good starting point for financial
empowerment.

Imagine a box called Income. While the size of the box may vary, the
purpose is the same for all of us, we fill it either each month or periodically,
with money that we earn as we convert our physical and mental effort into
cash.

For most of us reading this newspaper, we fill this box each month with
salary, though other small inflows could be interest, profits, dividends, bonus
or repayments on loans given. Now imagine an outflow from this box each
month. This is the expenses flow or the living cost that allows us to maintain
the human capital and keep it going to work the next day, month and year,
so that it keeps filling the Income Box with money.

We now have an inflow and an outflow (of course, the outflow will take into
account all expenses including taxes and loan repayments). And look
carefully at the bottom and you see some notes and coins left over. Those
are your savings, or the excess of the result of the human effort over what it
needs to sustain it.

This can be spent as well on lifestyle and other consumption. Why save? But
we do instinctively tend to hoard. This instinct comes from the knowledge
that human capital has an economic lifespan that is shorter than the
biological one, or that we will stop working many years before we die.
We may have to stop working not because we want to but because the body
and mind can’t pull any more (yes, I know, that seems unbelievable today).
So we save today mainly with the aim of getting our Income Box filled even
at a time when the human capital is unable to go to work to generate money.

Now imagine a box into which all your savings flow. This is your Wealth Box.
The aim of saving regularly is to help this Wealth Box get bigger and bigger.
It must get so big that when the human capital finishes doing what it can,
the income from this Wealth Box will replace the salary income. Of course,
along the way, there are other smaller goals such as buying a house,
financing the child’s education, but the key goal remains retirement. What
happens if the human capital dies midway? Enter life insurance. Its role is to
keep the income stream flowing for those who share your Income Box, even
if the human capital dies midway.

Typically, write Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, and Kevin
X. Zhu in a monograph titled Lifetime Financial Advice: Human Capital, Asset
Allocation and Insurance, from which I drew parts of this analysis, you need
four to seven times your current annual income as life insurance cover to
keep the Income Box filled, even if you die midway. They recommend a term
insurance plan for the biggest insurance bang for each premium buck.

Of course, those with already large Wealth Boxes (Sachin Tendulkar, Shah
Rukh Khan) need no life insurance cover. Look at medical, personal accident,
household, car and other asset insurances in the same way. Medical and
personal accident covers aim to prevent the use of funds in the Wealth Box
to finance an unexpected illness or event that will cost more than what the
annual living cost can afford. Household, car and other asset insurances aim
to protect the physical manifestations of the conversion of your human
capital into material objects. That car cost you a full year’s human capital at
work, the diamond set, two months, the mixer and grinder, five days of
work.

By paying a small charge and buying these insurances, you prevent having to
work all over again to buy these things. The house itself, very interestingly,
is something that you have leveraged your human capital into the future to
buy today. It is against the steady stream into your Income Box in the next
15 years that will continue to pay the EMI (equated monthly instalment) for
the house that you live in today. What if you die? Well, those who share your
Income Box will pay, be evicted from the house or you buy an insurance
cover. The chief role of insurance is to protect the income stream from the
human capital and the assets that it has created. All else is smart sales.
When we convert savings into investments, we begin to fill our Wealth Box
with several products. Each product has a certain role in the Wealth Box and
seeing that we’re out of space now, why don’t we meet next Wednesday to
take this forward?

A quick recap: Dhan Chakra, or the circle of wealth, is a system that gives
one a mind map of a life cycle of money flows and the place of various
financial products in it. We looked at an Income Box, that fills due to the
conversion of our labour into money.

The surplus over all living expenses from this fills the Wealth Box, which aims
to swell in size such that once we stop working, the income from this box can
keep us eating till we die and then leave something over for the squabbling
siblings.

Last week, we were at the point when the savings from the Income Box were
moving towards the Wealth Box. But before they enter, they need to
transform from cash (that loses value due to inflation and taxes) to
something that will generate a surplus or grow in value after inflation and
taxes are taken into account.

It is this decision of transforming the money in the bank into a mutual fund,
a stock, an insurance plan, a pension plan, gold or a plot that is one of the
toughest to make. This transformation is the key determinant to how big and
steady the Wealth Box will be. How soon you can stop going to work just to
fill the Income Box. And whether you will travel the world at 60 or count each
note and coin.

The first rule when buying a product to convert cash into a Wealth Box
product: don’t buy something that throws off income today. Our human
capital is still getting converted to cash, through work, and we want to hoard
such that the Wealth Box is big enough to see us through our non-working
silver years. This leads to a need for products that build a corpus, or a large
sum of money, rather than give an immediate return.

For example, instead of a Post Office Monthly Income Scheme that gives a
guaranteed return each month, a large lump sum can be converted into an
instrument that will grow over the years, like an equity mutual fund or if you
are zero risk, a National Saving Certificate.

Divide up the products you buy into four buckets. These are called: No-Risk,
Market-Linked, Real Estate and Gold. Into the No-Risk Bucket goes your
provident fund contributions (that earn 8.5% tax-free currently), public
provident fund contributions (8% tax-free), any other small saving products
such as National Saving Certificates.

It is easy to recognize a zero-risk product, just find out if the return is fixed
in percentage terms and the time of the investment in months or years. In a
No-Risk Bucket will go products that have no surprise at the end of their
lives. The usual rate of such return is 1 percentage point higher than
inflation. The function of this bucket is to provide the Wealth Box with
stability.

Into the Market-Linked Bucket go products such as equity, balanced mutual

funds and direct stocks. These have the ability to make the box grow much
faster than the products in the No-Risk Bucket. But why do we want risk at
all? Isn’t it safer to be safe?

The average return from the Indian equity market has been around 15% a
year over the last 30 years. The most misguided investor, who invested at
the market peak of 3 April 1992 at the height of the Harshad Mehta bull rally,
is up an average annual 8%, and this is not taking into account dividends.

And a person who has regularly put in Rs1 lakh each year into the Sensex for
the last 20 years is looking at a corpus of Rs1.3 crore today. But we got to
hold our money and faith for at least 10-12 years for equity to give its return
kicker.

For direct stock pickers, the returns can be much higher or much lower. The
safer way to fill the Market-Linked Bucket is to stick to broad index-linked
products, so that the risk due to too few stocks is removed and since an
index will always hold some of the best companies of a market, and the
return stream is fairly predictable.

The Gold Bucket is small. It does not take more than 10% space in the
Wealth Box. Its chief purpose is to keep a small liquid fund of money that is
free from the risk of inflation. So you can add it to your Risk-Free Bucket,
except that, for Indian families, this could be the pool that will fund the gold
that our big fat weddings consume. Instead of gold coins or even chains, buy
gold exchange-traded funds—they are cheaper, safer and much more liquid.

The Real Estate Bucket remains tinted with black in India. The high
transaction costs, understated property values and laborious legal system
makes real estate as investment a messy asset to have in your box. Unless
you are able to deal with the high transaction costs in terms of money and
time, keep the bucket filled with the one house that you live in.
The size of the buckets and how steadily we fund them will determine the
size of our Wealth Box when we quit working. At that point, the corpus is
used to buy income-generating financial products that keep the Income Box
tinkling and our cappuccinos coming. Maybe with no sugar now!

Equity investing is safe: just follow the rules

Everybody knows that roads are unsafe, people get run over and cars smash
into each other. Yet we continue driving, riding, walking and crossing these
roads because there’s a set of rules that defines road use and works 90% of
the time.

Equity investing is no different. There is a set of rules out there that allow
long-term wealth creation. But you’ve got to look at both sides of the road
before crossing it.

The first two rules of investing are: invest regularly and make an asset
allocation. The first gets us to make a saving target and puts money away in
a financial product other than a savings deposit each month.

The second wants us to split that money into two buckets—debt and equity—
and stick to that allocation unless our view on our risk-taking capacity or
personal situation changes.

The debt bucket is full of provident fund contributions, Public Provident Fund,
fixed deposits (FD) and bonds. The equity bucket brims with direct stocks
and equity funds. So far so good.

The toughest rule to wealth creation is Rule 3: Rebalance that portfolio.

What this rule says is this: If I start investing with a certain asset allocation
in mind—say I am comfortable putting half my money in the equity bucket
and the other half in risk-free debt bucket—I need to come back to this each
year.

This I will do by selling the asset class that has risen more and buying the
one that has fallen (or risen less). For example, if after the first year, equity
rises 20% and debt gives an 8% return, then I sell some equity funds and
put more money into an FD. If equity falls 20%, I break an FD and buy more
equity funds.

Sounds great in theory, but does it work in the real world?

Let’s look at some data. I begin with a notional investment of Rs1 lakh in
April 1990 and decide to split it equally between equity and debt. For the
sake of neatness, I am making a one-time investment rather than a regular
investment time series.

I choose that date since it was the time just before one of the biggest dips in
the market index, and of course, this was near the beginning of the modern
Indian equity market. For number crunching, I used the total returns data
that includes not just the index’s rise and fall year-to-year, but also adds
back dividends into the return. In this case, I used the CMIE Cospi total
return index. For risk-free returns, I used the one-year FD rates taken from
the Reserve Bank of India’s Handbook of Statistics for the same period.

So, it is 1990 and I’ve put Rs50,000 into the equity market and Rs50,000
into a one-year FD that gives me 9%. Over the year the stock market gives a
total return of 37.72%. My equity bucket is now at Rs68,860 and my debt
bucket has Rs54,500.

My 50:50 asset allocation is now off the rails and is at 56:44. Equity
investing rules now insist that I sell equity (the outperforming asset class)
and buy FDs (the underperforming asset class). This is the toughest call to
make for investors worldwide—to sell an asset even as it soars each day.For
the sake of an argument, suppose I managed to rebalance my portfolio each
year for 19 years. Now it is 2009 and my initial Rs1 lakh is Rs13.51 lakh.
That’s a year-on-year return of 14.69%. Sounds good.

But what if I had not rebalanced and let the portfolio run on? I would have
Rs8.38 lakh, or an average annual return of 11.84%. The difference between
the two annual rates of return may look just 3 percentage points away, but
over 25 years it means being at Rs15 lakh or Rs30 lakh.

Punters call it profit booking—take a part of your money out when the
markets are high or when a target price is met. But for the safe-lane driving,
seatbelt-wearing retail investor, rebalancing is a great way to get the benefit
of profit booking without the active calls or the index watching.

Equity investing is safe, but you got to follow the rules.