On the brink of revival

Lack of financial expertise has proved expensive for Surat-based Roy as his corpus is meagre and his goals are approaching fast. The only way out is to invest — a lot.

Bibek Roy with family
Name: Bibek Roy
Age: 48 years
Monthly income: Rs 85,000 (post-tax)
Financial dependants: Two (wife, daughter)

Bibek Roy, an assistant vice-president in an MNC, is not a "finance person". So he picks stocks on "instinct" and chooses funds based on "views expressed in TV programmes and magazines". He does not know about a fund portfolio and the various tools of analysis are alien to him. The reason he chooses a recurring deposit over an SIP is because the former can be initiated by a simple instruction to his bank branch, which automatically transfers Rs 10,000 from his bank account to the deposit.

Clearly, these are the makings of a financial disaster. Especially as Roy is 48 years old, uncomfortably close to the deadline for achieving most of his goals.

The excuse about his unfamiliarity with finances is too flimsy. In a career spanning 23 years, Roy ought to have educated himself about managing his finances.

Unfortunately, this is not a part of any mandated curriculum. The initiative must be taken by the investor. The result of not investing early in the right financial products is evident in Roy's slim portfolio. His financial assets total Rs 6.2 lakh. In addition, he has bought a two-bedroom apartment in Surat worth about Rs 26 lakh.

Iris calculates that Roy will be able to achieve his financial goals only if he invests a sizeable Rs 76,144 every month. For Roy, this seems to be impossible. His posttax monthly salary is Rs 85,000, of which he spends nearly Rs 20,000— 23.5% of his income. The EMI of his home loan and two personal loans eat away another Rs 45,000, or about 53% of his salary.

After subtracting the average insurance premium of Rs 9,395 and a Rs 10,000 recurring deposit, Roy's cash flow generates a surplus of only Rs 605. So the question is not whether Roy's finances are on track, but whether they can be salvaged.

Portfolio Analysis (click on link to enlarge)

Yes, at least in part. To do so, the first priority is to pad up Roy's surplus. On top of our hit list are the premiums of the expensive insurance policies. Roy is 10 years away from retirement and, therefore, does not need too much cover. He can opt for a term plan of Rs 10 lakh, which will cost about Rs 6,500 annually.

We suggest that he convert four money-back policies into fully paidup plans. This translates into an annual saving of about Rs 34,000. He can stop paying the premium of his Ulip bought in 2003. It will add another Rs 10,000 to his pile. The premiums of the two Ulips that he bought last year should also be stopped, but giving them up is tricky. The loss will amount to Rs 74,000, the collective annual premium for both the Ulips.

Iris suggests that Roy swallow the bitter pill. The first reason is that at least two years of high charges of the Ulips are still left. Second, the opportunity cost of Rs 74,000 is very high. Roy can invest the money every year in a mutual fund which has lower annual charges. More importantly, he can use it to prepay the two expensive personal loans taken at interest rates of 13% and 18%.

This suggestion follows a very basic financial principle. It is unlikely that the Ulips will give Roy returns greater than 18% or 13% in the short term. Borrowing at a rate higher than what he will earn on his investments is foolish.

Another reason why Roy should give up the Ulips is that the money can contribute towards his daughter's education, for which he requires about Rs 5 lakh within one year. Clearly, Roy has some tough decisions to take.

{mosimage}Streamlining his insurance basket should add about Rs 9,000 to Roy's surplus. If he prepays even one personal loan, the sum surges to Rs 21,500. The next step is to invest the surplus in the correct asset class.

Damage control

As Roy is lagging painfully behind in the race towards his goals, we suggest that he accelerate his pace by investing more in equities. However, this advice is dangerous as Roy is completely unaware about how the markets work. This ignorance multiplies the risk of investing in equities.

Roy's solution for this Catch-22 situation is roping in an expert to take these decisions. This too is unlikely to work. An investor must be equipped with some financial knowledge to help an expert decide the asset allocation and risk profile of his portfolio. So Roy cannot get away with the excuse of not being a "finance person". The permanent solution is to read up on the fundamentals of financial planning.

{mosimage}In the meanwhile, he can direct his surplus to mutual funds that have been performing consistently. Iris suggests that he choose from HDFC Top 200, DSP Black Rock 100, HDFC Prudence and HDFC Equity. These are equity diversified funds that should be the staple of every fund collection.

What about his own basket of 10 funds? Roy can retain DSP Black Rock T.I.G.E.R., but the other funds are not appropriate to his risk profile and investment acumen.

For instance, Kotak Indo World Infrastructure, Reliance Diversified Power, SBI Infrastructure, Sundaram BNP Paribas Energy and UTI Infrastructure are sector funds that have no place in the portfolio of someone who is clueless about how the sector is performing. They are more risky as well as the choice of stocks is limited. Such funds do not have the hedge provided by diversified funds, which place bets across all industries.

Similarly, Roy must not take the risk of investing in mid-cap companies and should exit the Birla Sun Life Mid-Cap fund. Those like Kotak Growth, which focus on companies that have the potential of a high upside, are also risky for Roy whose finances require a long dose of steady returns.

A brand new fund basket

This is why random stock-picking is a complete no-no. Unlike his choice of funds, Roy's hit-and-trial method has managed to put some good names in his stock portfolio— Reliance Industries, Reliance Petroleum, IDBI Bank, among others. Fortune has dealt some good cards to Roy, but this may not be the case forever. So it is best to exit direct equity and funnel the proceeds to mutual funds.

When is it a good time to sell the stocks? Roy can either wait till the markets recover so that he does not have to book losses, or he can exit the stocks at a loss as the money can then be re-invested.

For the debt component of his portfolio, Roy should concentrate on tax-efficient options like the Public Provident Fund. The income from a recurring deposit is taxable, so it is best to divert the money to the PPF. Though the income from a five-year fixed deposit is also taxable, it is a popular choice among investors as it qualifies for the Section 80C tax exemption and is a safe long-term investment. For the same reasons, Roy can also invest some of his surplus in these.

According to the asset allocation suggested by Iris, Roy must invest about 35% of his surplus in debt. But his resources are scarce and the clock is ticking for goals like his retirement. So if Roy wants, he can focus on mutual funds for a while and slowly graduate to the recommended asset allocation. This ensures that his equity investment has more time to grow.

Despite our strategy, Roy's goals will not be achieved fully. The reason is his late start at building a nest egg. As his target is high, we suggest that Roy consider extending his career beyond retirement to reduce the required corpus.