Name: Mayank Sharma Age: 32 Years Monthly income: Rs 70,000 (post tax) Financial dependants: Two (wife and child)
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One usually learns from experience. But when it comes to financial planning, it may not always be the case. This, because in the process of learning, you may pile up unsuitable financial products that are difficult to get rid of (read, high cost of exit). Also, past mistakes can have a lasting impact and may affect your current financial plan.
Take 32-year-old Mayank Sharma. The Ghaziabad-based zonal manager in a financial services company admits to floundering his way to his current knowledge of finances.
Sample this: his first instrument was “a combination of tax saving and investment” that he now knows to be a Ulip. He bought it in 2003, unaware of the high upfront charges and without knowing where his money was invested. Since then, he has added another Ulip, an endowment and a money-back policy to his insurance kitty, and has come to the conclusion that a term plan is the cheapest form of insurance.
Sharma has finally got it right. But as we said, he has learnt the lesson the expensive way. Not only is he saddled with unwanted insurance policies, but his annual premiums are very high—about Rs 1 lakh for a cover of Rs 16.25 lakh. Of this, Rs 10 lakh worth of cover is provided by one term plan bought in 2006.
The impact of these policies on his current finances is clear—the premiums reduce his monthly surplus by nearly Rs 9,000. Consider the opportunity cost of the money: had he spent the same amount as premium to buy a term plan, it would have provided a cover of almost Rs 3 crore.
So the first lesson to be learnt from Sharma’s mistakes is that you should understand the product before investing in it. Your strategy will and should evolve with time, but that is not an excuse for investing in the wrong instrument. This will save you from having to take course correction measures that we shall suggest for Sharma’s portfolio.
His monthly takehome is Rs 70,000 (post tax). Of this, Sharma spends about Rs 20,000—a reasonable 28.5% of his income. Clearly, his expense planning is on the mark. Last year, Sharma bought a duplex for Rs 25 lakh. The down payment was made with an overdraft from a bank at 12% interest rate on a reducing balance. The outstanding amount is Rs 6.5 lakh. To fund the balance, he took a home loan of Rs 20 lakh at 12.25% interest. The EMI works out to Rs 21,212, or 30% of his salary.
Though the home loan EMI does not make for a chunky portion of his income, the credit route taken by Sharma is not advisable. One should never fund a purchase entirely through loans, even if it is for an appreciating asset like a house. If your investments give you higher returns than the interest rates, a high leverage would be a smart decision. But if the markets take a downturn, as in recent weeks, the loans will hurt more.
In Sharma’s case, the situation is worse. The worth of his total financial assets is less than the bank overdraft. For equity exposure, he has invested in three mutual funds and in a basket of 11 stocks, which together are worth Rs 4.46 lakh. For debt investments, Sharma has chosen the National Savings Certificates and the Public Provident Fund, in which he has parked about Rs 1.16 lakh. The total investments add up to about Rs 6.12 lakh—Rs 38,000 short of his bank overdraft.
Obviously, we cannot advise Sharma to withdraw from his savings and prepay the loan. This would wipe out his savings completely. Iris suggests that he continue to deposit a part of his monthly surplus of Rs 16,948 in the overdraft account to reduce the outstanding balance. If he is confident that in the long run his mutual funds and stocks will give returns at a higher rate than the overdraft interest, he should focus on investing. If not, he should funnel a majority of the surplus in the overdraft account.
Sharma’s choice of mutual funds is good. It is a balanced mix of large-cap and mid-cap funds. He invests via systematic investment plans (SIPs) in Birla Sun Life Tax Relief and Reliance Regular Savings fund. Iris suggests that he start a SIP for the third fund, HDFC Taxsaver, too. The SIP amount should depend on his strategy for repaying the overdraft.
Though Sharma’s stock kitty has given him good returns in the past, it is dangerously lopsided. Three stocks, namely DLF, SBI and Reliance Industries, constitute about 70% of his stock portfolio. As a result, our first impression was that he is clueless about the dynamics of equity markets. But when we discussed his stock-picking strategy, the assumption turned out to be wrong. Sharma told us that he had done a fundamental and technical analysis of the stocks he had bought. He gave specific reasons as to why each of the 11 companies would do well in the long term. So how did a fairly aware investor miss out on the highly skewed allocation of his stock portfolio?
Sharma has made the same mistake as many of our past patients—overlooking the big picture. He did not measure the performance of his stock portfolio as a whole and failed to see that it depended only on three stocks (see Dangerously High Bets). Iris strongly suggests that Sharma choose a benchmark and regularly measure the performance of his stock kitty against it.
Also, in a basket of 11 stocks, a single stock should not constitute 40% of the portfolio’s value. Regarding insurance, we suggest that he immediately buy a term plan of at least Rs 25 lakh for 20 years. The urgency is that he has taken loans equal to this amount. The annual premium will be about Rs 7,200. He can continue with the ICICI Prudential Cash Back policy as it should give him higher returns than some other debt instruments. He should exit the expensive endowment policy, but only after he has built a sizeable debt portfolio. The pain period of high upfront charges for both Ulips is over. Sharma can continue to pay the premiums for as long as he can to build a bigger corpus. The one good thing is the current asset allocation of his portfolio. For the first time we are not advising any change. But Sharma has to invest more to meet his goals.
Cover choice{mosimage}Rahul Aggarwal, CEO, Optima Insurance Brokers Sharma has a collection of six insurance policies but is still not adequately covered. The reason is a haphazard approach to insurance. To avoid making this mistake, here are four factors that you should consider before buying an insurance policy: First, cover the risk
Your priority should be to cover the risk of untimely death in the most affordable way. Therefore, the first insurance policy must be a term plan, which is the cheapest form of insurance available. Timing of maturity
The economic risk ends at about 60 years of age. By this time most people have paid their long-term loans and have funded the education and marriage of their children. So time the maturity of a policy with this age. For instance, if a 30-year-old, who will retire at 60, takes a policy with a tenure of 25 years, he will still have five years of unprotected risk. It will be very difficult to take a policy at 55 years and it will be very costly.
Financial objectives
Life insurance policies can be effectively used to fulfill long-term financial goals like saving for a child’s education or buying a house. But they are not an efficient way to save for short-term goals. Expected returns
Ulips provide the policyholders an opportunity to gain exposure in the stock market with the aim of increasing returns on their investments. Insurance companies provide various fund options to match the risk appetite of a policyholder. But do not expect more than 15-18% annual returns from Ulips.
Buying a life insurance policy is an important decision. Do not choose a policy due to peer pressure or to save taxes. Make this a productive investment for yourself. |
