The fun of Wealth mangement!!

Hi Friends!!

Life has suddenly started resembling an adventure movie- with the startling pace at which things around us are changing everyday!! It’s not just the economic events which consume most of the space in media these days, but also other geopolitical events like US presidential elections; the MNS propaganda in Mumbai; blasts in Assam and violently fluctuating stock market movements everyday- volatility seems to be at an all-time high!!

Well, coming to the topic of this article, I have been spending some of my time in the past few days trying to figure out the manner in which I can best utilize the cash lying idle in my bank account. Everyone these days is talking about cash being the king; but cash lying idle in a savings bank account can’t even cover inflation. It’s my effort through this article to share some ways which I think can be useful in managing our wealth and making our cash work!!

Over the next few paragraphs, I have mentioned the different asset classes where our money can be invested; the importance of diversification; tax benefits on investment and an arbitrage opportunity which can fetch you a small (but risk-free) return. The ideal candidate I have in mind while writing this article is a salaried individual who falls in the highest income tax bracket; is yet unmarried and has a time horizon of at least 8-10 years to build a substantial portfolio.
How much cash must be there in my savings bank account?

• I know it is a feel-good-factor to have a lot of cash in our bank accounts- it gives a sense of accomplishment when we check our bank balance; but apart from that cash is the worst kind of asset class an investor can possibly think of!! This asset class; which earns a 3.5% p.a. pre-tax income (or 2.45% after-tax return) which Indian banks offer on savings account; has the potential to destroy our wealth in terms of purchasing power.
• But we can’t keep a zero cash balance in our account either- there are recurring monthly expenses, contingent unforeseen expenses, cash needed for infrequent trips, shopping and other purposes. I suggest a formula which can spare us the pain of determining the minimum liquid cash required.
• The formula is not to let more than 3 months of our recurring monthly expenses as liquid cash. The logic is simple, one month cash is what we need on a regular basis, and this can stretch to two months expenses if we have to travel, shop or have some other one-off requirement whereas three months is an extreme case when we need money for an unplanned or unforeseen event.
• Now considering a lavish personal monthly expenditure of 30% of the cash salary credited to our account; I think the maximum amount of liquid cash we need to keep in our savings account is close to one month of cash salary component (3*0.3*monthly cash salary). It’s better to enjoy the privilege of having 2-3 different bank accounts- when some of them have a good ATM network, some have good online and phone banking facilities and some may be willing to offer us value-added services.
• Now that we know what our “working capital requirement” is; we need to know how we can utilize our surplus cash.

Fixed Income investments- slow but steady way to enhance wealth

• There are different ways by which we can earn fixed return on our money- bank fixed deposits (FDs), Fixed maturity plans (FMPs), Public provident funds (PPFs) and corporate debt depending upon the conditions prevailing in the market.
• I think PPFs are evergreen fixed investment vehicles because they help us to save money for a longer time horizon (the minimum lock-in period is 7 years). Also, they help in saving tax (up to a maximum amount of Rs 70,000 is tax free under section 80c)
• FMPs are funds floated by asset management companies and mutual funds for a fixed time horizon- 1 month, 3 months, 6 months and so on and provide an indicative return on the investment close to the interest rate regime prevalent at that time. Although FMPs invest in debt instruments, the catch here is that they don’t guarantee a rate of return. But they carry an advantage in terms of tax savings- income from FMPs is subjected to dividend distribution tax (which is lesser than 30% income tax) and can also be adjusted for inflation index. Thus, FMPs are good investment vehicles for individuals looking to park their surplus cash.
• The next instrument is also the most common one- bank fixed deposits. I would like to recommend some good deals in FDs offered by the banks right now. Kotak Mahindra bank is offering a rate of 10% p.a. on a 10 year FD. It looks very ordinary, but I think it’s a good opportunity to lock in such a high rate of interest for 10 years – presently interest rates are high because of severe global liquidity issues but that may not be the case a few years from now. What differentiates this scheme from others is that there is no premature withdrawal penalty- in other words we get an option to earn 10% interest if interest rates are lower in the future. On the other hand, if interest rates go further up, we can redeem this money without any penalty and invest in the other high interest schemes. Similarly some banks are offering handsome rates of 10.5% on 390 days, 590 days and 890 days FD. The only disadvantage is the fully taxable status and the less flexible nature of most FDs.
• Now the difficult question- how much money shall I park in fixed income instruments? Well, there are no clear cut answers but it’s our endeavor to explore how we can best enhance our investments. I think 60% of our monthly cash surplus (monthly cash salary minus monthly recurring expenses) can be invested in fixed maturity instruments. And, out of the different options available PPFs can be used to the maximum limit (i.e. 70,000 annually), the remaining can be invested in FMPs, FDs and corporate debt according to the time horizon for which we don’t need the cash back for some other purpose. Corporate debts by some government bodies like NHAI have a favorable tax treatment but these schemes are not very frequently available.
• So, for an individual with a monthly cash income of Rs 50,000- the fixed income investment can be close to 21,000 per month after accounting for monthly expenditure of Rs 15,000 (60% of monthly surplus or 0.6*0.7*50,000). On an annual basis this comes out to be Rs. 2,52,000!!! After exhausting the tax free limit of 70,000 in PPFs we still have nearly Rs.1,82,000 for investment in other fixed income schemes. A prudent choice needs to be made between long term and short term schemes and also considering the tax benefits offered by FMPs.

Equities???- give me a break !!!

• We have a very short memory and try to recall only those instances which have happened in the recent past. Of course, the recent plight of stock markets across the world has made many individuals shy from investing in equities. But equity is still considered to be a lucrative asset class for wealth enhancement in the long term. This opportunity is compounded by the depressed prices prevalent right now and expected to remain subdued over the next few months, may be some years.
• Equities offer another opportunity in terms of favorable tax treatment (15% tax on gains if we sell off within a year and no tax beyond a year!!). Also, it probably is the only asset class which gives us so much choice and flexibility in terms of sector wise exposure, time horizon and dividends.
• Remember friends, we still have 40% of our monthly cash surplus available with us. Now, the amount of equity investment depends upon the risk appetite of an individual, I think the money which we direct towards equities must vary between 25-40% of our monthly cash surplus. This comes to Rs 8,750- Rs 14,000 (for a monthly salary of 50k) based on the opportunity offered by the market and our risk potential. On an annual basis, this turns out to be a substantial investment of Rs1,05,000 to 1,68,000!!!
• There are many ways by which we can invest in equities, but we need to choose the one which is the most optimum for us. Remember that we have exhausted just 70,000 from the limit of 1,00,000 on tax free income prescribed under section 80c. So, it’s a wise thing to invest at least 30,000 annually in tax free mutual funds. This provides us distinct advantages in terms of tax savings (not only on gain from investments but also on our regular income!!!), longer time horizon which spares us the pain of timing the markets and a substantial amount of savings (most tax saving MFs have a lock in of 3 years).
• Out of the remaining amount to be invested in equities (over and above tax-free MFs), it’s an individual’s call whether he/she wants to manage his/her own portfolio of stocks or wants to invest in MF with a particular theme or sector wise exposure. There are many mutual funds available to choose from; an individual can look at the past few years’ return history and the sector specific allocation of MFs to decide the ones he / she wants to invest in. Those who like to invest themselves need to be careful about diversifying their portfolios across value/growth stocks, large/mid cap stocks and diversification across sectors as well. Also, there must only be a few well researched picks in the portfolio because adding too many stocks can make monitoring difficult and can also cap the gains from the portfolio.

Alternative investments!!!

• Debt and equity investments are not sufficient investment vehicles if we consider a long time horizon of more than 10 years. We need exposure to some other asset classes as well which can help in diversifying our wealth and have a potential for generating superior returns in future.
• Two common asset classes in this category are Gold and Real estate. Its worth noting that these two asset categories offer a very good opportunity in terms of utility derived from investing in them. Gold is widely used as jewellery and real estate can provide utility either in terms of rental income or using the property for our own use (self-rented)
• Gold is usually considered a hedge against inflation and also the ultimate haven of safety. Now that we have just 0-15% of our monthly surplus left to invest, some of you might be wondering whether it’s still worth exploring the alternative asset classes!!! I would like to remind that there are other components of our salary which are not paid out by the employer on a monthly basis as cash. These include medical allowance, leave & travel allowance, annual bonus, on site allowance etc. This can be a significant amount for some of us. Alternative investments can be considered when we have satisfactorily invested in debt and equity, have a decent life style (don’t require to buy a major consumer durable for our day to day use anymore) and have adequately insured ourselves (both medical and life insurance!!)
• Real estate is an investment where timing plays a crucial role- more importantly because it’s a single bulky investment and a few percentage points can make a huge difference in absolute terms. Leverage can be used to invest in real estate. Buying a flat is more convenient by paying 25% upfront and the remaining 75% financed by a bank. This has a major advantage in terms of tax savings too. A total amount of Rs 1,50,000 annually as interest expense is tax-free under section 24. So it’s better to finance the house in such a manner to claim the maximum tax benefit!!!
• I would like to mention that the money required for real estate and gold is usually large and this can be made available from our earlier investments in debt and equity as and when we feel like booking profits or the need to buy gold or real estate arrives.

The ideal scenario

• The optimum scenario would be one where we have all the working assets at our disposal (the best consumer durables) and we still have a substantial cushion of earning assets which can help us maintain and enhance our lifestyle.
• A very important thing that must be kept in mind is to avoid over-exposure to any particular asset class. This is difficult to visualize when we start our investments because the amounts invested are not significant (especially on a monthly basis). But after a few years, the power of compounding starts playing its role and these assets start inflating. It’s very important that we don’t let our exposure to any particular asset class go beyond a comfortable level (as a proportion of our total wealth). This way we can hedge ourselves against unfavorable price movement in the particular asset class; in short reduce our risk.
• Partial profit booking and redemptions from inflated asset classes and channeling this money into other / sometimes more lucrative assets can be doubly rewarding.
• I think our exposure to a particular asset class must not be more than 25-30% of our total net worth (sum of all the assets we own minus the total liabilities we have to pay)

An arbitrage opportunity for salaried individuals!!

• A few employers have a policy of giving tax-free loans to their employees. This loan carries some tax liability in the sense that the interest calculated according to the market rate is added to the salary component which is taxed accordingly. Assuming an interest rate of 12% and tax slab of 30% this comes out to be less than 4% tax liability on the loan amount.
• If the funds loaned can be deployed in a risk free manner so that they earn a post tax return greater than 4% then we have an arbitrage opportunity to exploit.
• This is not difficult if we invest this money for equal to/less than 1 year in bank FD/ FMPs earning close to 10% p.a. Even after paying taxes we get a spread of 3.5% on FD (even more for an FMP!!). This is a small spread but why leave it when you can earn without any effort. Moreover, when the loan amount rises over a period of time, this small spread too can fetch handsome gains

Just a small recap after a lengthy article ....

• Liquid cash doesn’t earn returns; so maximum liquid cash must be 3 months of our monthly expenses; the surplus has to be “disposed off”.
• Fixed income investments- approximately 60% of monthly cash surplus spread across FDs / FMPs / PPF of different maturities depending upon interest rates and our cash requirement. Out of this 70,000 annual investment in PPFs is preferable.
• Equities – an exposure of 25-40% of monthly surplus is advisable. Out of this at least 30,000 annually in tax-free MFs, the remaining across value/growth, large cap/mid cap and sector wise diversified portfolio of stocks.
• After substantial insurance cover and consumer durables, investment in real estate and gold can be made for a long term wealth enhancement perspective. Timing and leverage are important because of the bulk amount required.
• Churning across asset classes and restriction of exposure to a single asset class can reduce our risk and enhance returns.

Guys, I hope you will benefit from some, if not all, of the points mentioned in this article. I wish I could have finished this topic in a comparatively shorter article but given the amount of detail this topic required; I was not able to do so. Moreover, there may be some more asset classes which could possibly have been worth mentioning here. Though, individuals have different risk and return objectives and we can’t apply a rigid set of rules for everyone, some amount of flexibility can be applied to the above mentioned logic to suit his / her condition. Wealth management, if followed in a disciplined manner, can work wonders for us. And it’s better that instead of “working for money” we make our “money work for us”.

I hope you will enjoy the process of managing your wealth and see it grow substantially by the time you grow old!!

Regards
Tanuj

(This article is a compilation of my academic, professional and personal knowledge in this field. Please feel free to comment and suggest changes you would like to see in my next articles. Also, in case of any doubts or further clarifications, don’t hesitate to contact me on my mail id- I would try my best to resolve them!!! )