Committed out of ignorance, inertia, laziness or confusion, these mistakes can add up to a fortune over a life time. Though mistakes are costly, they are deceptively simple to understand and overcome, if you notice them. There are more potent scamsters than Harshad Mehta hidden in your investment behaviour. What follows is a compilation of 10such common though costly mistakes that every earning individual should relate to.
But the purpose of the list is not merely to pinpoint where you are going wrong. Look at the mistakes with a different perspective and you see nuggets of wisdom on the fundamentals of financial planning. Hidden in each solution is the way you ought to save and invest. Here’s a tip on how to extract the best of the story: scan all the mistakes and focus on those you commit. Then re-read it from start to finish. We are sure you will have a clearer vision of your investment goals and strategy. A bonus: look out for the financial intelligence meter.
Confusing salary with income...and how to avoid it
Do you assess your financial worth by the number of zeroes in your pay slip? Naturally you plan expenses and savings accordingly. Worse, you even calculate income tax on that basis. You are underestimating your income and tax.
You’ve just filed your tax return and can’t help pat your back. Exemplary financial planning helped you breeze through the task. Investments matched financial goals and tax exemption limit was exhausted. Only, all calculations were based on your pay cheque.
What about the fixed deposit (FD) that matured last August? Or the interest earned from your bank accounts? These and more are a part of your annual income. The best financial planning is meaningless if you haven’t calculated your finances right.
This oversight leads to under-utilisation of your money. Neither do you spend the “extra” income nor do you invest it intelligently. The opportunity lost due to this negligence could cost you up to 6% return—the difference between the interest rate on a savings bank deposit and on an FD. Even your investment style is affected.
You may not invest in equities because you have to pay the insurance premium. The “unaccounted” sum could have made a re-allocation possible.
Naturally, your tax return also shows lower income than what it really is. Though unintentional, this puts you on the wrong side of the law. The good news is that the new tax return forms have specific provisions for income from other sources. So it can’t escape your eye. Two out of five income tax queries that MONEY TODAY receives relate to tax treatment of interest income. The remedy? Track incomes from investments too (see checklist) and include them in your financial planning. Now, you may pat your back.
Investing without a clear plan...and how to avoid it
Would you drive to a new destination without a map? No, right? Then why treat your journey towards investment success any differently?
Most middle class Indians are good savers, but not so good investors—the difference is lack of a proper purpose, a plan, for savings. Begin with prioritising your needs into short-, medium- and long-term investment goals.
For instance, planning for a vacation (short term), saving to buy property (medium to long term), and retirement planning (long term).
Often investors stumble at the starting point while defining investment objectives; this in turn gets their financial plan in a tizzy. Needless to say, it’s important to take into account your age, your investment time frame and how far you are from your stated investment goals.
Investment objectives can also be classified into categories like safety, steady income and growth—this will spell out the route your plan will take you along.
This is where your propensity for risk comes into play, a very crucial factor that demands brutal honesty. If you are unable to stomach the volatility of the market, your objective is likely to be safety or income focused. But if you are willing to take on volatile stocks then a growth objective may suit you. The final stage in strategy formulation is asset allocation and portfolio building—carefully picking diverse investment instruments that suit you (see Mistake 4).
Just charting out a clear plan isn’t enough. In fact, that may be the easy part, but sticking to it, especially when all other indicators seem to be against you, can be the true test. If you keep your emotions in check and regularly update your strategy in keeping with changing market dynamics and personal situations, joining the millionaire’s club may not be a pipe dream after all.
Having mismatch between strategy and objectives...and how to avoid it
Having an investment strategy is a good start, but what good is a plan that that does not accommodate your goals? Or a plan that is not executed well?
So you have listed out your financial goals and worked out a strategy. But how can you ensure that your battle plan really suits your objectives? By setting a realistic time frame for each of your goals because that above all else will influence your decision regarding the types of investments to choose.
Most investors park their money in the stock market for the short term and opt for debt instruments for the long term. This is exactly the opposite of what they should be doing—investing in stocks for the long term and in debt for the short term. The longer the time frame, the more aggressive the investment can be. For instance, if you are saving for a down payment on a house that you hope to buy in three years, your money should be in much more conservative investments.
But that does not mean you park your funds in a fixed deposit—Rs 1 lakh in an fixed deposit earning 9% will grow by Rs 29,503 in three years. But if you choose a good mutual fund, you could earn almost double that amount in the same period. And it would be tax free too.
Putting eggs in one basket...and how to avoid it
Or the wrong baskets. Heaping all your savings in one asset category or in one instrument type not only increases your risk but you also lose out on other high-return or more tax-efficient investment options.
What goes where and for how long? All asset allocation seeks to answer this question. And the factors that determine the answer. Your income, age, dependants, financial goals and risk appetite, to name a few.
But whatever be the investment mix, the underlying mantra is: spread your risk. Even if equity is earning you stupendous returns, balance your investments by parking some funds in debt to hedge against the risk of losses. On the other hand, if you are betting solely on fixed income and debt instruments, chances are you will never reach your dream corpus. So, invest in equity too.
The first level of diversification is to distribute savings among equity, debt and real estate. And how do you figure out this ratio?
Take more risk when you have fewer commitments but park funds in safe instruments as your riskappetite goes down or responsibilities increase (see Mistake 3). Diversification doesn’t end here. Within an asset class, select among instrument types. If it is debt, choose a mix of fixed deposits, fixed maturity plans (for tax benefits), small savings schemes and debt mutual funds.
Equity investments are more complicated. If you are a daredevil investor in direct equity holdings, make sure your investments are not concentrated in a single company or industry. Sector diversification is important to tide over times when a whole industry faces a downturn. Buying too many mutual funds is diversification at its worse. You may own multiple funds that invest in the same industries or even the same companies. So do check the fund portfolio before investing.
Sticking to the same investments at 25 and 55...and how to avoid it
Invested and forgotten. The best of investments can give disastrous returns if they are not tweaked according to the changing investor profile or market movements.
Happily invested ever after? Hardly possible. Invested money is in constant flux. Changing market moods require you to monitor the direction of your investments and make changes to keep them on track of your goals.
These goals also change with time. So while at 30 saving for an overseas holiday is top priority, at 40 you will want to invest for your children’s education. Just as these objectives change, so should your investment style.
Some investment thumb rules do not change with age but there is a marked difference in investment strategy. Early in your career, it is best to go on an equity overdrive. Ideal equity to debt ratio is 70:30.
The underlying assumption is that at a young age you have no or few dependents and hence lesser responsibilities. Consequently, your risk-appetite is high. While this makes it easier to stomach losses, a jump in your returns will contribute handsomely to your ultimate corpus.
Through the power of compounding, smaller amounts invested regularly from your 20s give impressive returns by the time you retire. At an older age, exposure to equity should be gradually reduced. Shifting focus to fixed-income instruments ensures secure returns. This is the time when expenses peak and income surplus is at its lowest.
Broadly, the equity to debt ratio should be 40:60 but actual asset allocation will be driven by factors such as medical expenses, children’s education, marriage, etc. Don’t sit on investments just because they gave great returns in the past. Blind loyalty is not a virtue in financial planning.
Taking inadequate or wrong life insurance...and how to avoid it
Most Indians are very particular in taking an insurance policy, and most of them take the wrong one.
If your shirt size is 42 inches, would you buy one marked 38? We know someone who does that all the time. He’s the average Indian buying an insurance policy. He doesn’t care whether the policy fits him or what benefit he gets from it. All he’s interested in is how much he will pay the insurance company because that will help reduce his income tax.
Insurance policies should be bought according to the size and length of financial cover one needs, can squeeze. If someone is the sole breadwinner, the insurance cover should create a corpus that earns enough to replace his income. Some financial planners say the cover should be 4-5 times the annual salary of the individual. Evaluate insurance needs with change in life stages, lifestyle and when getting into debts. For instance, take a term insurance plan when going in for a real estate purchase, especially if you are funding a large proportion of it with a home loan.
Then there are riders available that can be added to your life policy which can widen the scope of cover to include risks against health emergencies and disability.
Many investors buy traditional endowment and moneyback insurance policies which promise a big corpus on maturity, not realising that the returns from such policies are a meagre 6-7%. These are high-cost, lowcover policies. Term plans are the best form of insurance.
You can get life cover for a very low premium. True, a term plan does not have a maturity value, but the savings from the lower premium can be invested in a more lucrative investment option. If you want a second insurance policy, opt for one that doubles up as investment.
Ulip is exactly this kind of product. To get the most out of it stay but with the policy for at least 10 years and use the facility of free switch between funds.
Overlooking the various costs of investments...and how to avoid it
Smart investing is often not just about hunting for best returns, but also about looking at the most cost-efficient options.
Your mutual fund investments have risen by a fantastic 50% in one year. Happy, you decide to sell units and invest profits elsewhere. You get in hand less than 50% though—only xx% actually. That’s Rs xxx gone on an investment of Rs xxxx. Who shrunk your returns? Your ignorance actually.
Mutual funds manage your money for you, but not free of cost. The charges come in several forms. If you are investing in a new fund (NFO) the value of the unit you bought will initially be even less than what you paid for. Say Rs 9.xx against Rs 10 you were charged. That’s accounted for by the entry load and marketing expenses—the exact amount will depend on the type of fund you invested in.
Of course if your fund managers do well, the NAV will go way beyond Rs 10 sooner rather than later. But even if the scheme doesn’t do well, you will pay expense ratio—percentage of a fund’s assets taken out annually to cover management fee and other expenses. And if you exit the fund before a stipulated period, there could even be an exit load to pay. Your real returns will be net of all these charges.
Even if you invest in stock directly, there are charges you shouldn’t ignore. Right from broker’s commission (which is xx % or a flat fee on some online trading portals) to fee for keeping shares in a demat account and then the securities transaction tax. From insurance to real estate to loans, every financial deal has a charge. Knowing of them is not only important to get the best possible deal (one with the lowest charges), it also makes your return calculations and investment strategy realistic.
Being credit friendly when you shouldn’t be...and how to avoid it
Walk into a showroom and drive out in a new car by making a small down payment. Swipe your credit card to buy a new refrigerator and repay in easy EMIs. Don’t underestimate the prohibitive costs of these conveniences and their effects.
Living on EMIs is a tempting thought. You get to enjoy an asset much before you have the money to buy it. But before you get the credit card bill for a consumer durable converted into easy EMIs, ask yourself if you really need to take the loan.
Many people take a loan just because it is being offered. They may have money lying idle in their bank accounts but that doesn’t deter them from accepting the offer. They readily pay 12-15% on that loan while their money grows by a measly 3.5% in the bank. Net loss: 8.5-11.5%.
The auto mart is a fecund ground for such unrequired borrowings. Salesmen and brokers entice buyers with discounts so that they borrow a larger proportion of the total cost. Don’t get swayed by the “fabulous offers” and “cash discount” schemes.
If you are being offered an attractive deal, it is because the broker expects to earn a hefty commission from the lending bank. If you are buying a car on a loan, keep your downpayment as big as possible and the loan as small and short as possible.
In some instances it may even be sensible to liquidate some investments to avoid taking a loan. If the returns you expect on your investments are lower than the interest you are paying on your borrowings, it is better to sell that investment and retire the loan.
Starting retirement planning at 40...and how to avoid it
The key to finishing rich is to start early, but how many 25-year-olds prefer to save up instead of fuelling the consumption trends of the nation? And banking on just the pension plans from your employer won’t get you very far.
It’s difficult to think ahead to your retirement when you are young. There are so many things you want to do and so little money at your disposal. Yet investing a relatively small amount of money from an early age, say in your 20s, can save you from having to invest more when you are in your 40s or 50s in order to be able to live comfortably in retirement.
In fact, nothing can be more dangerous for your retirement plan than a late start—the later you start, the more you’ll have to save to make up for lost time. That’s because your investments lose out on the power of compounding.
For example, let’s assume your retirement age is 60 years. If you invest at the age of 30 years, then your investment has 30 years to grow at the existing compounding interest rate but if you have invested at the age of 55 years, then it has only five years to grow. Another advantage of starting early is that you can afford to make mistakes and still have time to recover. But even if you missed the early bus, it’s never too late to make amends. You may never discover a procrastinator’s fund offering high returns with low risk, but stepping up savings could still ensure a good life.
Banking on savings that you could outlive...and how to avoid it
You are going to live longer, perhaps much longer, than your previous generations did. That’s good. But make sure you don’t run out of savings in the old age.
What happens if you outlast your retirement corpus? There’s a good chance that many of us will because of a combination of factors.
At the very fundamental level, average life expectancy has risen by about 4 years in the last 10 years alone—from 63 to 67 years. This wasn’t an issue for people who worked and earned in the era of defined pensions which guaranteed an inflation-lined monthly income till death. That’s a passé now, even for government employees. This means estimating and investing for your financial needs years and decades beyond your income earning years.
Sure, many of the big ticket expenses like house, car, children’s education or marriage is over by the time you retire, but recurring expenditures tend to rise as you age. Spending on medical care, transportation, domestic help and suchlike is bound to go up when you are a senior citizen. As these needs grow, so does the cost of meeting them— thanks to inflation that will keep eating away the purchasing power of your corpus. As any long-term investor knows, the power of compounding can work wonders. Inflation too works on the same principle—only it makes you poorer.
Rs 1 lakh may sound like a big figure today but even a nominal 6% inflation over 40 years will reduce its purchasing power to Rs 10,000. Imagine the nightmare if inflation is higher. Compounding the problem is the mismatch between strategy and objective (see Mistake No. 3). People often invest long-term funds in low-yield risk-free options. With inflation eating into your returns, a monthly withdrawal of Rs 40,000 will completely deplete a kingly corpus of Rs 50 lakh invested in a “safe” option within 13 years (see table).
The only way to ensure you are not left high and dry when old and feeble is to build a bigger corpus than you think you will need to live comfortably. Some experts suggest saving twice the amount you expect you would need. What’s the downside of this approach? You'll end up with too much money at a stage in your life when you have the time to enjoy it.