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Tuesday, October 23, 2012

Common Mistakes in Choosig the investment products

SEVERAL investors associate financial products with specific time frames. An investment decision is typically defined in terms of how much to invest over what time frame, and when the money would come back. This probably stems from purchase of traditional products such as bank term deposits and saving certificates. This mindset of investors tends to foster few sharp practices among sellers of financial products. Investors should guard against them in their own interest.

The first set of products comes with a lock-in period. The lock-in period is imposed on products where a tax-concession is available. The intention is to defer taxes. If the withdrawal happens into retirement, when income levels are lower, the investor is able to provide for along-term goal using the tax concession, while earning and paying a higher tax. This benefit is loss of several investors, who look upon any investment with a lock-in period, as one that has to be redeemed at the end of the period. A three-year lock-in in an equity-linked saving scheme is typically redeemed at the end of the period. A three-year period is too short to realise the benefits of equity investing. Over longer horizons, the product is likely to generate a good level of capital appreciation, riding through at least one bull cycle in the equity markets.

The second product where investors have an erroneous holding period view is the unit linked investment plan (Ulip). Here, the minimum contribution period of five years is mistaken for the maximum contribution period for the payment of premium. Eager to save taxes, investors commit to high premium, pay it with difficulty over the minimum period, and hope to get the money back after that period. Later, they realise that much of the premium they paid has gone into paying commissions and costs, and the investment is not worth a lot. The truth is that Ulip is a long-term product that needs to be held for 10-15 years, to derive any benefit at all.

The third common error is using a fixed-time period as the frame in choosing investments with low rates of return. Investors routinely invest in products such as endowment plans of insurance companies, since they believe that the discipline of regular investing is good. They do not check whether the return is adequate.

They are happy to receive a lump sum at the end of the investment period, which can be deployed to meet large expenses. The focus is on putting money aside and getting it back, with little attention to whether the money has grown at a reasonable rate over time. Investors buying into gold-saving schemes of jewellers also fall into the same trap. They invest small amounts for a fixed period, happy to be able to buy gold with the money accumulated at the end of the period. What they fail to ask is whether the money they part with has earned a market rate of return, which it should. Else, they are providing cheap funding to the jeweller.

The fourth and the more serious error in judgment is when investors buy into spurious schemes, only because there is a fixed schedule of investment and return presented to them. From the days of teak farms and finance companies, there have been conmen, who have created products with fixed contributions by investors and a promise to return a fixed amount years later. The credibility of the proposition is enhanced by making risky ventures look certain, in a neat table of cost and benefits.
 
It is important to see that fixed holding periods are a thing of the past. Investors today can decide on any investment horizon they like, and choose from flexible investment options that enable entry and exit at their convenience.

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