Good intent bad choices

Pune-based Chaitrali Deshmukh has a good investing approach. But she should be careful while choosing financial instruments for the best returns.

Print Edition: May 1, 2008

Chaitrali Deshmukh
Chaitrali Deshmukh
Age: 29 years
Monthly income: Rs 11,500 (post-tax)
Financial dependents: None
Click here to see Chaitrali's complete portfolio analysis
If you include her contribution to the equated monthly instalment (EMI) for a home loan taken jointly with her father, Chaitrali Deshmukh, 29, invests 81% of her income. You would guess her pay cheque to be very hefty, right? Wrong. Deshmukh, a call centre employee earns Rs 11,500 a month. And not only does she save, she is intelligent enough to invest it. There are many lessons from such investor behaviour.

It demonstrates that she understands the power of compounding. She is inclined to build assets. And monthly investments in equities reveals that she wants to exploit her high risk appetite. But Deshmukh has faltered in choosing her financial products. We will correct this flaw shortly. Before that, a look at her current investments.

More than half of Deshmukh’s take-home salary goes into paying the EMI of the home loan (she pays Rs 6,000 while her father pays Rs 18,000 for the Rs 24-lakh loan they took last year). The value of this real estate forms a significant proportion of her net worth—present and future. She contributes Rs 2,000 to household expenses. This leaves about Rs 3,500 to invest every month.

Deshmukh has three insurance policies, one single-premium Ulip and three equity mutual funds apart from some bonds and fixed deposits. Of her monthly surplus of Rs 3,500, about Rs 1,000 goes as premium for the three insurance policies (Rs 11,800 a year). Another Rs 2,000 is invested in the three mutual funds through systematic investment plans (SIPs) started 12-18 months ago.

It’s a well diversified portfolio but perhaps not a well chosen one. She has two endowment insurance policies and one money-back policy and pays a hefty premium for a combined cover of Rs 2.5 lakh. “I bought these policies because the agent told me I could save a big sum for my retirement,” she says. Well, her investment of Rs 8,400 every year in the two endowment policies will grow to around Rs 5 lakh in 25 years. Considering that almost Rs 1,000 goes in as the risk premium for the Rs 2 lakh cover, the balance would earn an annualised return of only about 7%.

Choice defines returns

Deshmukh has not invested in good funds.This is a critical flaw and can make a huge difference to the corpus she finally accumulates. Here’s how a laggard can eat into your returns:
  Value of SIP of Rs 1,000 after
5 years
15 years 25 years 
3.98 lakh12.33 lakh
13 82,2945.13 lakh19.76 lakh
16 88,4156.64 lakh32.04 lakh
If it’s any consolation, Deshmukh should know that her choice of policies is a common mistake. Most people buy insurance policies just to save tax and even if they don’t have dependents. However, her reasons for choosing mutual funds are shockingly naïve. None of the three equity mutual funds in her portfolio figure in the list of best performing mutual funds. All three are from Reliance Mutual Fund and Deshmukh bought them because “the agent told me that the Reliance Group, particularly Reliance Industries and Reliance Petroleum, were on an upswing”. Huh? The financial performance of a group or company has no bearing whatsoever on the returns from the mutual funds it manages.

The good news is that Deshmukh is aware that she hasn’t made the best choices and is eager to correct the mistake. She has already decided to terminate one of her high-cost endowment insurance policies and take a term plan instead. Exiting a policy before three years means losing the premium paid till now but Deshmukh is prepared to take that hit.

This would free Rs 4,200 a year—money that can be used to buy a Rs 5 lakh term plan to cover her home loan of Rs 6 lakh. In fact, she should also see to it that her father is adequately covered since he has an outstanding loan three times bigger.

She can also consider turning the two other policies into paid up policies after three year’s premiums have been paid. When a policy is turned into paid up, the premiums stop but the insurance cover continues. The company deducts an amount from the corpus every year as premium for the life cover.

Deshmukh should not invest in debt any more. Her PF contribution of Rs 800 a month is a sufficient addition to debt investments. It may be noted that her income may rise in the coming years and her goals may change if she gets married.

Last year, Deshmukh opened a demat and share trading account for investing directly in equities. She should do this only if she develops interest in and understands equity markets. Even then, the mainstay of her investment should be mutual funds. Retail investors are unlikely to match the stock picking ability of fund managers who have access to research reports and critical information on companies and sectors. While we do not discourage investment in direct equities—especially at this age when Deshmukh can take high risks—we suggest she monitors her portfolio closely. Her fund portfolio needs an overhaul.

She should stop her ongoing SIPs in equity funds. Almost 70% of her mutual fund investments are in small-cap and mid-cap stocks. This is an unnecessary risk. Instead, Iris suggests she switches to large-cap funds such as HDFC Equity and Franklin India Bluechip. A good bet could be HDFC Prudence, a balanced fund with a large-cap bias. It has outperformed several equity funds in recent years.

Deshmukh’s goals are a mixed bag—some require small, some large and some extra large investments. This year’s shopping list has a digital camera and a laptop and would cost her about Rs 50,000. This can be taken care of partly by redeeming the existing mutual funds which would fetch her about Rs 30,000. She should invest Rs 1,200 a month in a fixed maturity plan for the balance Rs 20,000.

Then there’s a car (or a twowheeler) in about five years. Deshmukh should invest Rs 1,200 a month in an equity fund for a downpayment of Rs 1 lakh. A loan can finance the balance. Finally, she plans to stop working when she is 40-42 years old and aims at a retirement corpus that earns Rs 20,000 a month at today’s prices. At 6% inflation, this will be about Rs 48,000 a month. We suggest she pushes back her retirement by at least 5-6 years or scales down her needs to Rs 10,000 a month.

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