Personal finances and Tax

Why Tax Sops?

The government gives a variety of tax sops to encourage certain behavior. For instance, the tax savings under section 80 c gives tax benefits for savings up to Rs 1.5 Lakh per year. The idea is to get people to save and invest money. Similarly section 80 ccg gives tax benefits for investments of up to Rs 25,000 for people having income less than 12 Lakhs. The idea is to get small investors to invest in mutual funds so that they get good returns without inordinate risks.

Of course, sometimes the tax sops stop making sense. For instance, on a first self occupied house, a maximum of Rs 1,50,000 deduction is available. But on second or more houses, the deduction available is the entire interest less 70% of deemed rent. In the present scenario, with high interest, high property values and low rents, this second option may be several times the first limit. In other words, it gives very high deduction for people buying a second or more property which does not make sense.

Tax Sops and Financial Planning

While good financial planning takes maximum advantage of the tax benefits, it is not directed by tax benefits only. Good financial plans begin with the needs of the individual and once these can be fulfilled, the optimum tax benefit is taken. Often, however, people make mistakes which can be very costly.

For instance, most of the investment options under section 80 c require the investor to lock in the money 5 years. Schemes like NSC give returns of 8.5% but the interest is taxable. So even considering the initial tax savings, net returns are between 9% and 15% depending on the tax slab. Given that most personal loans and EMI schemes are at 14% to 16% interest rates, this is usually a losing proposition.

Of course, investment in PPF is way better because the interest income is also tax free. But since these are very illiquid (and early withdrawal is again taxed),  one needs to think carefully before investing in them.

Rules of thumb

If you are in the 10% tax bracket, then do not invest in tax saving schemes like traditional insurance and NSCs. If you are very certain that you will need money for 20-25 years, then invest in PPF.

If you are in the 30% tax bracket then you should completely meet the limit in section 80 c. Most of it will probably be covered by EPF and similar instruments. Also, you should not require to buy things (except house) on EMI.

If you are in the 20% tax bracket, then the difference between the two options are not significant. But if you do anticipate need for money in a couple of years, then it is better to not invest in locked up schemes.

Privacy, market decoupling and REITs

Real estate market in India is currently claimed to be in bubble territory. Certainly, the price increase during the boom period of 2004-2015 is unprecedented. While it has been a wonderful time for people who got on board before or in the initial stages of the boom, for people who did not purchase a house, it seems pretty hard. Worse, these are the people who are most likely to buy property at the worst possible time - just before the bubble explodes.

Privacy and market decoupling

So what has this got to do with privacy? Well, as per the original definition, a private citizen was one who took no interest in the affairs of the society. Given that most of the functions of a society are performed by markets today, I would call privacy as the degree to which a person is decoupled from markets.

When a person rents a house on a one year lease and license agreement, he or she is highly coupled with the market. Price changes would affect him greatly. The coupling decreases as the lease term increases and price stability is built in; however, often the "price stability" assumes other factors to remain constant. For instance, a 10% escalation clause would be fine in high inflation (and high salary rise) era but if inflation drops to 2% and salary increases follow suit then again issues arise.

Owning the house you live in significantly reduces the risk. You become much more disinterested in what happens to property prices.

Ticket size and Timing risk

Unfortunately, while owning a house reduces the risk associated with market movement, the process of owning a house increases it. In other words, if you purchase a house when the prices are high, you are significantly worse off. The real issue is that you can never be sure when the prices are high or low and since you must purchase the house at one go, you need to take up this one time risk

REITs

It is easy to see where all this leads to. REITs are a mechanism to "buy a house one square foot at a time". Basically a REIT (real estate investment trust) is a large corpus of funds that is invested in real estate. The investment into this corpus can be bought and sold in "small quantities". Sure, this costs money and my sense is that for REITs, the costs for managing REITs are likely to be 2-3% which will probably be of the same order as rents so your returns will be substantially lower than if you had bought a property. However, the benefits of diversification and small ticket size are significant since for many people there will be no other option.

In other words, once well managed REITs are available, you can invest in them in small amounts. They will allow systematic investment in property. For a person who has just started a job and would like to buy a house in 5-6 years, REITs would give an alternate mechanism to "decouple from the market". By investing a fixed amount every month, one can get rid of the fear of "what if property prices increase substantially". When one is ready to purchase property, one can just sell the investment in the investment in REITs and purchase the property.

For people who dislike paying interest and / or are not certain where they want to live in (probably because they are considering changing their job, career or city), these will be a boon and an alternative to purchasing a house on EMI.

Markets know best

It is not hard to come across investment opportunities that seem too good to be true. From the piece of real estate that can never fall in price because it is at a great location to the stock of a company that has great management so it will perennially keep appreciating are all "tips" that one often keeps hearing about. We also hear about the people who made a killing by actually investing in those. In this article, I will talk about when it makes sense to go by these tips and when it does not.

Efficient Markets

This is a technical term that actually is very useful to understand markets. Basically it says that the price of any item (including real estate and stocks) at any time is "correct". By correct it means that if you were to see the movement of price, it would increase in about 50% of the time decrease in 50% of the time. In other words, it is not possible, on an average to make profit.

How does it work?

While the proof and even the interpretation of this statement is very involved, some reflection will convince you that it should be correct. Consider the case of a property that is at a very good location. In this case, it may be the case that the property will be priced higher than others but why would it keep appreciating? On the other hand, if everyone knew it would appreciate than everyone would try to buy it and would make better and better offers to the seller. This would stop only when all the "excess appreciation" was factored into the price. Exactly the same thing works the company with a good product or a good management.

Can one make money out of tips?

A little reflection will tell you that the only way to make money out of tips like this is to get - and act on - them before others do. So your reaction may be to act on them immediately while others are still evaluating. This is often also mentioned in the tip itself. Unfortunately, that is unlikely to help you either.

The reason it does not work is because usually the person giving the tip has no special "love" for you. He could have given the tip to anyone else. Most likely, he chose the order in which to give the tip at random which means that a large number of people must already have received it and much of the price appreciation must already have taken place.

On the other hand, it is a great way to commit fraud. If even some people blindly believe on tips, than prices will increase for a short time. So the person giving those tips can hoard the item in question and sell it when the prices increase. This was the reason a why a couple of years ago promotional SMS about stock tips were banned.

But I believe in this tip

At times you will come across a tip that you think makes sense. Before investing on the basis of it, do ask yourself the following questions - 

1. What new information do I have that others either do not have or do not believe in?
2. Has there been any price movement in the last few days or weeks which may have been due to others getting the above information?
3. What is risk involved? What does it mean for my financial health?

When do markets NOT know the best?

This is one last thing that is important. There are a large number of cases when the market price may be wrong - often for large amounts of time. This often happens when

1. There is a monopoly - a single buyer or a seller.
2. Information is available to a select few - for instance when government comes up with a master plan for a city or a major contract is awarded.
3. Some new technology or innovation comes up - consider the dot com boom and bust
4. The world is going crazy - for instance when the central banks print a lot of money and flood the market with it

But in each of these cases again the only way you can make money is by getting out before everyone else realizes that they made a mistake. On the other hand, the potential to make huge losses is very large. If you realize that such a situation exists, the least that you should do is be very careful.

Controlling Expenses

Don't I get to spend more money after getting a job?

After getting a job, there will be a significant change in your financial situation. If your parents were well to do, your financial situation must have deteriorated significantly since you feel odd asking them for pocket money and your salary seems to get over before it even started. If you struggled to afford an eduction then you probably have money in your pocket but then again maybe you have a lot of responsibilities and your salary seems too small to fulfill all of them. Blessed is the odd standout who actually has more money just after getting her first job.

Controlling expenses is a hard thing to write about. This is because while the savers are all similar (they dont spend on anything), each spindrift is spends in his or her own way. So rather than trying to control expenses I will talk about something else.

What do you do with your time?

This is probably a strange question to ask in a personal finance blog. But spend a few minutes thinking about it and you will realize that it is a very important question. In fact, some psychologists believe that it is THE CENTRAL question of our existence. But this question is even more relevant for people who have recently got a job.

The reason this is important is that after getting a job, life changes significantly. You become - or are supposed to become - more mature, responsible and capable of taking your own decisions. Before taking a job, life was structured - often by others. College and classes decided when to study. You probably had a large group of friends with much social interaction. This group decided what to do with your free time. But after getting a job, your groups would probably have become much smaller. You will be surrounded by your professional contact most of whom are significant older. There might be a few "freshers" in your work place and a few college friend who you are luck live / work near the same place you do.

In other words, while you didn't have to do much to pas time in your college, now on one hand you have a job which exhausts you and on the other hand you have not much idea what to do in your spare time. It will be worth your time to write down ten or twelve things that you do - or should do when you have free time.

Where is this going along?

If you have actually done the exercise in the last line, you will realize that more often than not, you do not have an idea let alone a plan. And as a result you go with the flow  making decisions at the last moment. What typically happens when we do so is that rather than doing things that give us real satisfaction, we go for things that are easy and give us momentary satisfaction.

For instance, you may like traveling of hiking but that is not an option at 4:00 p.m. on a Sunday afternoon (because you got up at 2:00, because you slept at 4:00 a.m., because you were watching a rerun of Friends, because you had no idea what to do on a Saturday night - you get the idea...). On the other hand, if you had planned something a couple of days ago, you might have slept earlier and got up at 6:00 in the morning to beat the traffic and visit a nearby hillsite.

I have noticed that when we "go with the flow" somehow the decisions are very "costly". I think we are more vulnerable to advertisement and all the glamorous things that are heavily advertized are costly.

So what do I do?

Now spend more time trying to imagine what you really want to do with your time - it could be education, hobby, hiking, traveling, joining a community or cause or so on. It is very unlikely to be shopping and eating out. Further, you will realize that there are lots and lots of ways to do this things at low costs.

More importantly, you are doing things that you really like so money spend on them is well spent; on the other hand money spent because some crafty commercial conned you into buying something you didn't want and couldn't afford will make you miserable.

Alternative to EMI schemes

EMI schemes and personal loans are the best justification for planning your personal finance. Hence planning your finance is an alternative to them - and a very profitable alternative. This post is for those people who dont seem to every have money with them when they want to buy something and as a result keep resorting to EMIs.

Cost of debt

Let us look at what the implications of EMI are. Consider purchasing a phone worth 8,000 Rs at a 6 month EMI of Rs 1400. This is fairly representative scheme and you may image that it is not very costly. But in fact, it costs you Rs 400 and the interest rate is just around 17%. Similarly, the interest rate on personal loans comes to anywhere between 14% and 16%. Credit card debt is even worse at 24%-36%.

If an EMI is taken as a one off case then it may not seem costly but the reality is that taking things on EMI is usually a sign of bad habits that cause recurring problems.

Planning

The first benefit of planning is that it avoids impulse buying. You may be tempted to buy stuff that you do not need on EMI since the gratification - the reward of buying is instant but the costs come over the next few months. However, if you pay in cash (or by debit card), you will need to plan before making large purchases - and in the process you will have to ask yourself whether it is really worth the money or not. In the cool and comfort of your home, away from the glitz of the shop, as you weigh the options, the unnecessary purchases will be avoided and things that matter most to you will remain.

The second major advantage of planning is that you save a LOT of money. 400 Rs may not seem like much, but if you make a purchase every month, it quickly will. Worse, when you use EMIs for small things like a washing machine, you will also use it for larger things like a car. THAT can easily put you back by a whopping 25,000 Rs. Don't believe me - do the maths yourself.

How to plan

Systematic planning involves a lot of steps but for now we will just begin with a quick a dirty plan - but one that is better than no plan at all. First of all, you need to have a budget for shopping and capital purchases. This will include almost every item sold in the glitzy stores in a mall for instance clothes, shoes, accessories, electronics, furniture, furnishings and so on. Note that as a rule of thumb, the budget should be between 10% and 20% of your take home salary; begin with 10% and try to keep it there unless and until you have to increase the budget.

Now keep atleast half of you budget in a "fund" - a piggy bank is the best idea. Whenever you have the impulse to buy anything, just add it to you wishlist. Put money into your fund every month immediately after getting your salary. At this time you can also check you fund value and decide if there is anything you would rather buy from you wishlist or wait till your fund increases.

Of the remaining money, add a fourth to your wallet every Monday and feel free to use that amount - and only that amount to "splurge".

So for a person who earns 20,000 Rs per month, the monthly budget is Rs 2,000. Of this 1,000 will go into the fund and every week he will add Rs 250 to the wallet for spending.

As you go about this you will initially spend the the money in the first 2-3 day itself and will feel miserable the rest of the week, especially on weekends. Over time, if you keep at it, you will learn to keep waiting for all of the weekdays so that you can have a good weekend. If you really want to become a pro, you can try saving something from the 250 Rs (say 50 Rs) so that once a month you can have a better party.

If the budget of seems too low - even after taking it all the way upto 20% of your take home, you need to take a hard look at your overall planning which we will do in the next post.

Gold and Gold ETFs

Gold v/s gold ETFs

I like ETFs. However, Gold ETFs - especially for long term are an exception to this rule. The reason is simple - Gold ETFs are too costly. The typical fund management fees is 1%. As compared to this, when you buy gold, typically in the form of coins and sell them back, the total transaction cost is 10% (Yes it is that high). So if you plan to hold gold for more than 10 years, it is better to buy coins.

When should one use gold ETFs?

Gold ETFs can still be used to invest in gold systematically - start and ETF with 1 or 2 grams of gold per month and every couple of years or so, purchase coins or jewellery and sell the ETF - on the same day. This way, when you are buying gold, you do not need to worry about the price.

Why should one invest in gold?

But why exactly do you need gold? Gold is the investment of last resort - when something totally unexpected happens and you lose everything else, physical gold is likely to still have value. A major market meltdown, a war or hyperinflation are likely scenarios. A portfolio that has 5% in gold is hardly hedged against such events (such events are likely unhedgable) but with that gold, you can begin a new life. Incidentally, another reason for preferring physical gold is that a large number of such meltdowns would mean that the ETF would become worthless.

How much to invest in gold?

Typically, 5% is a good amount to invest in gold and gold jewellery. Generally this amount is easily taken care of by the jewellery component. For people who have their other financial goals on track I would suggest keeping 10% of their total savings in gold.

Conclusion

So this is another area where I differ from traditional finance advise - rather than Gold ETFs, I would suggest you to keep physical gold in a place that is secure but reachable in case of emergency.

Discounted cash flow

Discounted cash flow seems like a very difficult concept but it is not so in reality. However, it has a few common sense implications. For people who want to understand and make financial plans, it is necessary to understand its basic concepts. The advanced working can be done in excel.

Basic ideas

1. Time has value - one rupee today is more valuable than one rupee a year later.
2. Time value of money depends on risk taken (for future income) or opportunity cost (for future cost).
• Thus, one rupee a year later in FDs is MORE valuable than one rupee a year later in equity.
• Similarly, one lakh rupee today are more valuable than one year later if you have an outstanding personal loan (with high interest that you can prepay) vis-a-vis if you are going to invest the money in FDs and pay 30% tax on the interest.
3. To make decisions, simply calculate that impact in terms of today's money that they are worth. This will level differences in the time value AND risk.
4. Discounting - to find the present value of some money that you would get 1 year from now, just divide the amount by (1 + discount rate). So if the amount is Rs 55,000 and the discount rate is 10%, the present value will be 55,000 / (1 + 0.1) = 50,000.

Example 1

Arun is buying a car. The dealer has two schemes, one in which Arun gets a discount of 50,000 and the other in which the dealer gives an interest free loan of Rs 6,00,000 for 1 year.

The present cost in first case is clearly 5,50,000 since Arun just pays 5,50,000 today. In the second case, he does not pay anything today but pays Rs 6,00,000 1 year from now.

If he has an outstanding personal loan of say 10,00,000 at 14%, then the present cost of 6,00,000 (which he has to repay) is 5,26,315. So it is better to take the interest free loan.

On the other hand, if Arun will put the money in FDs with 10% interest rate, on which he will pay 30% tax then the net return is just 7%. So the present cost is 5,60,747. So in this case, it is better to take the discount.

Example 2

Arun is investing in a house worth 1,00,00,000 by paying Rs 30,00,000 today and taking a home loan. The builder will pay all the interest till the house is ready 3 years later and the builder assures him that the house will appreciate by 25%. Arun expects the stock market to increase by 50% in three years and he believes that the risk in stock market is equivalent to the risk in purchasing a house.

For the house, the cash flow is -30,00,000 today and 55,00,000 three years from now. On the face of it, it seems like 80%+ returns. On the other hand, the cash flow in stock market is -30,00,000 today and 45,00,000 three years from now. So it seems that it is better to invest in the house.

However, that is not the case. Even if the risk of house appreciation and risk of stock market by itself is the same, things change because of the way the deal is structured. In the house case, Arun is borrowing 70,00,000 Rs from the bank to fetch higher returns. This leads to a higher risk. Thus, even though the house appreciates by just 25%, Arun fetches a return of 83%. However, if the house had depreciated by 10%, then Arun would have faced a return of -33% (the house would be worth 90,00,000 so after reducing the loan, Arun would be faced with a loss on 10,00,000 on a capital of 30,00,000). In other words, with leverage (i.e. taking loans), good days are better and bad days worse. So risk is higher.

Calculating the discount rate is difficult here. If the risk free rate (the so called repo rate) over the three years is 25%, than we can say that 25% is time value of money and remaining 25% (in stock market) is risk value. In the property purchase case, since the leverage is 3.33 (1,00,00,000 / 30,00,000) so the risk value should be 3.33 * 25% and total discount rate should be 108.25%. So the present value of the house is -3,58,900 while the present value in the stock market case is 0. In other words, it is better to invest in the stock market than in the house.

Summary

While evaluating returns, never simply add up cash flows at different points of time but discount them by an appropriate interest rate. For non risky instruments, the FD or repo rate (usually 5%-9%) is a good discounting rate and for equity or stocks, the stock market return (usually 12%-14%) is a good discount rate.

Also keep a look out for what the risk factors are. Anything that implicitly has higher risks (due to loans, uncertainty etc) needs higher returns to justify it.

Budgeting for Future Expense

Often we need to account for expenses that happen long in the future - like retirement or children's education / marriage. Here I present a few rules of thumb that I use to budget for these.

Rules of thumb

You can use items 1 and 2 for large expenses (like education or marriage) and item 3 for retirement planning.

1. If your requirement would cost 1 lakh today and it will be made Rs 25 years later, you can
• Save 25,000 today and be done or
• Save Rs 350 every month or
• Save Rs 85 every month and keep increasing every year in proportion to your salary.
2. If your requirement would cost 1 lakh today and it will be made Rs 10 years later, you can
• Save 55,000 today and be done or
• Save Rs 800 every month or
• Save Rs 450 every month and keep increasing every year in proportion to your salary.
3. If your retirement is 25 years away, save 25% of you expenses for retirement. If it is 10 years away, save 1.25 times your expenses.

Notes

These are some notes for people who may want to check these rules. Please feel free to ignore this section if you just want to use the rules.

1. I assume that the real rate of return is between 4% and 6%. These rates have been achieved over the past several decades in various index funds and are not too risky.
2. There is a well known rule called the rule of 72 which states that if the interest rate is x% than money doubles in roughly 72/x years. So with a 4% interest rate, it takes 19 years to double and with a 6% interest rate, it takes 25 years to double.
3. Given that life expectancy may increase, it is simplest to use only real returns during retirement. This ensures that you never run out of retirement funds.

Buying a car

In this post I look at the real cost of buying a car. I hope this would help people make a better decision regarding allocating the budget for a car. For the current analysis, I am looking at a car that costs around Rs 5,00,000.

Major cost factors

Fuel costs

We begin with a head that is most obvious - the cost of the fuel that goes into driving. While the cost varies significantly with the usage, it will typically be in the range of Rs 4,000 to Rs 10,000 per month. Generally, diesel will come out cheaper by around 30% as compared to petrol and CNG will be 50% cheaper as compared to petrol.

Insurance and maintenance

If comprehensive insurance is opted for, it will require around 25,000 per year. Further, annual maintenance costs (servicing, mandatory deductibles) will come to approximately the same - i.e. Rs 25,000.

Depreciation

If the car is sold after seven years at 50% of the purchase price, the annual depreciation will come to around Rs 35,000.

Interest

This is a component that is often missed. It is sometimes believed that if depreciation is accounted for interest is not required, but that is not the case. True, the depreciation is not a cash expense and so it should be considered to reduce the interest expense. Accounting for it will lead to an annual interest expenditure of around Rs 35,000 as reasonable interest rate of 12% per year.

Total

The total cost comes to around 1.5 to 2 lakh per year. Importantly, the fuel cost is just half to one third of the total cost.

Rules of thumb

With respect to a car, I use the following rules of thumb

1. 20% of the cost of car is the annual fixed cost. The fuel costs are extra.
2. Car cost should not be above 5% of your take home pay. Thus, your car budget should be three times your monthly pay.
3. For monthly usage of less than 2000 kms, it does not make sense to buy a diesel car.

Happy driving!

First five years of a job

In my previous post, I briefly talked about the percentage of income that can be saved by people who have just begun a job. In this post I will take that thread forward and talk about the milestone that such a person would reach five years into his job.

The Scenario

We look at the case of a hypothetical person, Arun who is reasonably well to do. Arun begun with a post tax salary of 50,000 per month five years ago (at the age of 22) which has since increased to 1,00,000. Further, Arun was lucky not to begin his career with significant financial responsibilities.
Just after passing out, Arun was not sure whether he wanted to study further, change his field nor what kind of work he would like. He was campus placed into a reasonably good firm which he changed after 2 years. His income grew steadily from 50,000 to 1,00,000 which averaged 14% annually. Given that inflation was over 8%, this was good but not exceptional.

Spending pattern

Arun's spends around 30% of his salary; one-third on rent, one-third on living expenses and the remaining on discretionary expenses. The rent and living expenses are low because he shares the rent with three other friends who are his room mates. He has not made any major capital purchases (vehicle, furniture or appliances). Neither has he invested in real estate.
His savings are primarily in EPF where the monthly contribution (his and employers) is Rs 10,000. The EPF balance is currently Rs 6 Lakh. Beside he has invested in the stock market via SIPs on an index funds. These accounted for half of his salary and today the corpus amounts to over 30 Lakh. He has an FD of around 5 lakh and a saving bank account balance which averages around 1 Lakh. He has no life insurance and only an employer provided health insurance plan.

Options

At his stage in life, Arun has a number of options open to him

1. If he finds that he is reasonably happy with and secure in his current job, he can purchase a house worth 50 Lakhs with a down payment of 10 Lakhs and 2 Lakhs being spent on legal expenses. Even if his salary remains the same and expenses double to Rs 40,000 (say because of getting married; the rent of 10,000 is saved), he will have savings of Rs 10,000 besides the EPF contribution. Together these will provide for his retirement while his remaining corpus of 24 Lakh can be used for other financial goals. This is something that would be called a typical life trajectory.
2. If he wants to change his career, he can go for higher studies. 5 lakhs will be sufficient for his living expenses for 2 years and the rest can be financed via an education loan (since these have tax benefits). But since he will still have a corpus of 36 Lakhs, his net worth will remain positive giving him a significant peace of mind.
3. If he wants to go for his own startup or professional service, again 5 Lakhs will be sufficient for 2 years living expenses and he will be able to invest around 12 lakhs into his venture. The remaining corpus of 24 lakhs will ensure that he still has something to fall back upon in case things do not work out as expected.
4. He could spend six months to one year traveling. While this may not appear to have direct monetary benefits, it can be highly educating and further would help Arun discover himself and what he wants to do in his life. The so called mid-life crisis at 40 may be avoided. Again this involve an expense of 16-17 Lakhs and allow a corpus of 24 Lakhs to fall back on.
5. If for some reason, there was an emergency in the family, Arun would be able to support to a significant extent. In a sense, this would have been the default path if Arun had significant financial responsibilities.

It is important to note that none of the last three options would have been available had a house been purchase an early age.

Takeaways

My takeaway from the above is that binding financial decisions - primarily the purchase of a house should always be delayed till there is personal clarity. A second takeaway is that liquidity of funds is important in ways that cannot be fathomed.
At a young age, it should be expected that wishes, hopes and aspirations will change significantly so the early financial decisions should be mode so as to increase flexibility.

Budgeting for your house

In this second post on a series on buying a house, I look at deciding the budget for a house. I assume here that the house is being bought for personal usage and not for investment. I look at a number of rules of thumb and show how they result in similar values.

Thumb Rules

1. The value of the house should not exceed 3-5x of your annual post tax income.
2. The EMI should not exceed 40% of your monthly post tax income.
3. After EMIs and expenses you should be able to save 15-25% of your post tax income.
4. The EMI should be twice the rent.
5. You should be able to make the down payment with 2-3 years of savings.

Justification

Much of the justification for the above come from models of expenses. For a family earning 1,00,000 Rs monthly after tax, the following seem reasonable.

• 30% (Rs 30,000) in monthly living expenses. This includes expenses on food / groceries, fuel, utilities, clothes, health, education, entertainment and other expenses.
• 30% (Rs 30,000) in rent and depreciation of major capital items like furniture, appliances and car. Of this, roughly two-thirds (Rs 20,000) will go for rent, one-sixth (Rs 5,000) will go as depreciation for car and remaining (Rs 5,000) will go as depreciation for appliances and furniture. The depreciation would roughly be the case if you have a car worth 3-4 Lakhs and total value of furniture and appliances worth roughly the same.
• 20% (Rs 20,000) savings for major financial goals other than retirement.
• 20% (Rs 20,000) savings for retirement. Half of this will usually come from mandatory savings (EPF etc) and the remaining half should be invested in equity via mutual funds etc.

 The ratios usually hold out over significant income range (say 25,000 per month to 4 lakh per month).

From the above we see that the rent is 20% of income so rules 2 and 4 become the same. Similarly after deducting the EMI of 40% of monthly income, the family would still be able to save 20% so rule 2 and 3 also become the same. 

Lastly, at current interest rates (10%), a 25 year EMI comes to around 1% of the house value. So if the house is 3.3 times your annual pay, the EMI will be (3.3*12*0.01) 40% of your monthly pay. Similarly, if the interest rates are 6% and the house is 5 times the annual pay, the EMI again will be 40% your monthly pay. So rules 1 and 2 again become the same.

Lastly, if you use all your savings (25-30%), in 2-3 years you will have around 75% of your annual pay which will be sufficient for 20% of a house that costs 3.5 times your annual pay. So rules 5 and 2 also become the same.

Together, these imply that with a monthly income of Rs 1 Lakh, you can buy a house worth 40 Lakhs.

But this is too low

This would be your first reaction, especially if you are actually living in a house with a rental of 20,000. Generally, such houses would sell for around Rs 1 crore. Please note the following caveats which shows that the above is not really an underestimate - 

1. We have not considered property taxes and maintenance expenditure on the house.
2. The above assumes that you are buying a ready to move in house. If it is still under construction, the EMI that you can afford goes down - almost by half.
3. The above also assumes that all the money for your other financial goals will come only from increase in income. So do not assume future increments for a higher value of the house that you can afford.

So the end result is that you really cannot actually afford a more expensive house.

Options

 You are then left with the following options

1. Buy a smaller house or in a less desirable location and downgrade your lifestyle.
2. Save more money from expenses and retirement savings to fund a larger house.
3. Buy a house or land in another city as an "investment".
4. Continue living on rent.
5. Unconventional ways to significantly reducing expenses (living with your parents, delaying / not having kids, extremely frugal living)

 Of course, none of these options are easy. You need to ask your why you want to own a house to really decide between them.

For people who have not yet married or are just married, my recommendation would be a combination of 4 and 5. Frugal living on rent will allow you to save a good amount of money; 70% of your after tax income is actually doable. 4-5 years of savings of that nature can easily result in a situation where you have saved 3-4 times of annual income. Such a corpus could open up a large number of opportunities.

Buying a House

Buying a house is one of the first things on your mind after you get a job. Part of the reason is that a house is a major source of security, stability and status. This is probably the biggest financial decision taken by most people. Yet, as the housing crises all over the world shows, this is a decision that is easy to get wrong.

Emotional Factors

Many of the mistakes that are made while people are buying a house are because of "emotional" factors associated with it. So I will address those first.

1. Status Symbol: Owning a house certainly is a status symbol. But you need to ask yourself how much are you willing to pay for purely the status part of it as a fraction of your salary. While the number will vary for different people, it should not be more that 10-15% of your take home salary. In any case, asking yourself this question and writing down a number will help you take much better decisions.
2. Convenience: Sure, it is much more convenient to not have to change a house every year or two. Further, you can decorate / customize your own house to an extent that nobody will allow someone staying on rent to. But you need to ask yourself when will these important enough - before marriage, after marriage or after having kids. On the other hand, do remind yourself that buying a house reduces a lot of flexibility. I know a number of people who bought a house and then in a few years switched cities because of their job. Many wasted several months in a dead end job because they did not want to change cities / the new offer was too far off. As a rule of thumb, you should buy a house only if there are a large number of opportunities nearby or if you plan to stay in your current job for 3-4 years.
3. Marriage: Few people openly talk about it but that fact is that in arranged marriages (and increasingly otherwise as well) owning a house is a big plus point. To be sure, a house is a sign of stability - and it is relatively more polite to ask if the prospective groom has his own house (and ask to see it) rather than asking what is net worth is. I would like to emphasize that one should concentrate on education, job, basic savings and house in that order and that you are probably better off not marrying someone whose priorities are significantly different.
4. Pressure: A number of people, especially bachelors buy houses not because they see any major benefit but just because their parents of relatives pressure them to. Spending a few hours trying to figure out your life plans will help a lot. If you have just got a job then typically you will not know what you want to do with your life; purchasing a house will be a major decrease in flexibility.

Financial myths

I now look at a few common misconceptions regarding housing.

1.  House prices never decrease. Not true. They decreased in Mumbai in the 1995-2003 period. Search on the internet for proof.
2. If you want to buy a house for self use anytime is a good time. Again not true. It should be common sense that if a decision does not make sense for one class of customers (i.e. the investor), it will not make sense for another class (i.e. the end user).
   This myth is probably spread to get more end users to buy in the current slow market. The justification probably derives from the efficient market hypothesis which says that a market cannot be timed (i.e. you cant be sure that if you wait prices will fall, no matter how insane they appear). Unfortunately, housing market in India is very far from being efficient. Besides, even if a market is efficient, the ideal way to invest is systematically (i.e. a small amount every month) so that temporal risk (i.e. the risk that price will suddenly change in a small period of time) is avoided. Unfortunately, that is not an option in India currently.
3. Rent is wasted money; it is better to pay EMIs. It is a surprisingly common myth that I have seen. Somehow people forget that the interest that you pay is as much a waste.
4. Returns on property are high, especially if you take a loan. This is partly correct to the extent that there are tax benefits on interest repayment. However, the bulk of high return is due to leverage - the fact that you are borrowing money to invest. As long as price appreciation (+ rent) is above interest rates, leverage will magnify returns; however if prices remain event flat for some time, returns will become significantly negative. Basically increasing leverage increases risk so the returns should not be directly compared.

In my next post, I will talk about setting a budget to buy a house.

Retirement planning

Retirement planning is hardly something that a person who has just started a job will worry about. Thankfully mandatory savings (EPF and gratuity) get us started. But it is important to have at least a rough idea of what this entails.

Rules of thumb

The following can come in handy while figuring out retirement needs

1. Assume that the corpus required will be 25 times your annual expenses
2. Assume that your expenses in real terms (i.e. ignoring price increases) will be slightly larger than your expense just before you had your first child. Do not consider rent and loan repayments as expenses
3. Plan so that all your loans and liabilities, especially your house loan will be paid off before retirement. This assumes that you will have a house (or equivalent money) before you retire.
4. Do not make any plans for the duration of your retired life. Over the last 50 years, life expectancy in India has increased by 25 years so by the time you die, you may well be over 100. Plan so that your funds never fall short.

Typically item 2 above comes to (or should come to) around 30% of your take home pay so your retirement needs will be around 12 times your annual pay when you had your first child. If the retirement horizon is 30 years, you need to save 10-12% of your income in high yielding mechanisms for retirement; if the horizon is 12 years, it will shoot up to 50%.

Where to invest

It is well kept secret that over long time horizon (above 15-20 years), equity indices are SAFER than fixed deposits or even government debt. This seems highly surprising but this is caused by the significantly higher returns in equity.

The instrument of choice will be mutual funds or index ETFs. As I have explained earlier, these will also double up as emergency corpus, keeping you away from high cost short term debt (like personal loans and credit card debt) and allow you to keep away from medical insurance (except for catastrophic insurance like accident, disability and critical illness covers). But these must be balanced by overestimating your needs and providing slightly higher for your retirement.

Ideal portfolio at retirement

 Ideally at retirement at the age of 60, a couple would have their own house and would be free of any debts or responsibilities. They would have a retirement corpus that is around 10 times their annual salary at retirement and expenses around 30% of their retirement salary.

After retirement

The retirement period has increased over time and it will not be surprising if it becomes 40 years by them a person in their thirties retires. Hence this is a large period and all rules for investing for large periods apply here.

In other words, the retirement corpus must primarily be invested in equities again via mutual funds or ETFs. Assuming a conservative real return of 4%, every month 0.3% of the portfolio value (at that month) can be moved to your savings account. The savings account should contain money for 1 - 2 years of expenses.

 

Life Insurance

Insurance is basically a mechanism to reduce risk by pooling it. It stems from a basic theorem in statistics - which is also apparent via common sense - that diversification reduces risk.

How it works

The life expectancy in India is reasonably high (over 65 years of age). Very few people die in their late thirties or early forties - mostly due to accidents. Their numbers may be some 5 to 10 in a thousand - let us assume that it is 1% for the twenty year between 30 and 49. Unfortunately, the families suffer a huge financial burden in these rare cases. Life insurance basically works when a large number of people agree to pool a small amount of money every year with the understanding that in case someone dies their families will receive 2000 times the money they put in.
The numbers I have put in above are fairly representative. Premium per lakh of insurance comes to around Rs 80-100 per year. This of course assumes that the insurance is pure insurance (also called term life) and is purchased online so as to save on agent commission.

How much insurance does one need

There are various mechanisms to calculate the requirement of life insurance. Please keep in mind that insurance is NOT a full replacement of the income that a person would have earned. Instead it should be considered as a replacement for the cash that would flow from the person being insured to others.
Typically one should first cover large debts like house loan and next look at large responsibilities. In the Indian context, these would include child education and marriage. Next, it must have enough funds for the remaining life of the dependents. A good rule of thumb for the last item is to have 25 times the annual household expenses.
In most Indian contexts, the monthly expenses and savings for children would come to somewhere around 50% of the monthly take home. Home loans should not be more than 3-5 times the annual take home. So total insurance would come to around 16 times the annual take home which results in a premium that is 1% of the monthly pay. In the absence of a home loan or in case where the home loan is already insured (as is often the case), the premium would come to 0.6% of the monthly take home.

Summary

The following rules of thumb can be used as starting points

1. Always purchase term life insurance and never traditional plan
2. Insurance is required once you have a family and typically till the age of 50; do not buy insurance for longer periods
3. Purchase insurance online after comparing rates
4. Typical premium amount should be 0.5 - 1% of your income; it the premiums come much higher or lower, you are probably making some mistake in calculating your insurance needs.

Health insurance

Health insurance is a big big thing in the US where it is pretty much mandatory. In India, it has just begun picking up. It is important to realize that health insurance as available in India is completely different from what is available in the US.

I don't like the health insurance plans in India. The ones in US, I like even less. But my opposition to the US plans is more ideological while my opposition to plans in India is pragmatic - Indian health insurance plans do not make financial sense.

What is Insurance?

From wikipedia, "Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment". Further, "The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate the insured in the case of a financial (personal) loss." (Emphasis mine).

Please note that the operative phrase is relatively small. In other words, something can be called as insurance if the premium is small as compared to the amount insured.

Typical Health Insurance Premiums

Consider insurance for Rs 5 Lakh. The premiums vary from Rs 3000-7000 (over 0-45 years) and then shoot up to Rs 40,000 by the age of 65-75. The total premium over a lifetime is over Rs 5 Lakh. But that is fine because the limit is really Rs 5 Lakh per year and not overall.

Is it really Insurance?

In no sense are the premiums relatively small as compared to the sum assured. But this makes sense. Health expenses do not vary significantly between people (unless in case of some catastrophic illness which I will cover later) so health insurance plans are really mechanism to spread your medical costs uniformly over your lifetime. This is thus really an annuity in reverse rather than insurance.

Issues

The average person should not care about the nomenclature but rather about whether the plans make financial sense or not. The problem with adding an intermediary is that it brings additional costs. Thus, it is more expensive to buy health insurance than to manage an emergency fund by oneself.

A larger issue is moral hazard - you tend to get medical (and sometimes quasi cosmetic) procedures done just because they are covered by insurance. I have seen multiple instances where people would not have done a procedure if they had to pay for it from their pockets. Since ultimately these costs come from the pockets of the insured, in effect, insurance makes people overspend on things that they would not otherwise have.

The only corresponding benefit of insurance would be that insurance funds are better placed to bargain and so costs may come down. My experience with car insurance however tells me that this effect is overshadowed by others.

When to get Health Insurance

It makes sense to get health insurance when you total net worth is very low and you have no liquid or semi liquid funds. But this is a temporary expense and should be eliminated in 2-3 years. On the other hand, catastrophic health insurance - which are for specified diseases (like cancers and heart issues) and provide 25 lakh and higher cover for a small (3,000 - 5,000 annually) are much more like insurance and should be taken.

For other cases, it is better to invest the premium in a fund and keep your other long term savings in a semi liquid form (like mutual funds or ETFs) to tide over emergencies.

SIP

Introduction

A Systematic Investment Plan is what financial theory recommends for the average investor. These typically involve making small but continuous investments every few days (or every month) in a predefined instrument - typically a mutual fund. The amount to be invested depends on the financial plan of the investor and the market prices explicitly are not used. This is completely opposite to what "common sense" recommends.

Here, I look at SIP in more detail and try to explain some of the theory behind them.

Timing

It seems self evident to the average investor that what matters in financial markets is timing. Basically one makes money by buying low and selling high. Everyone always knows someone who made a fortune by buying the right stock at the right price. By extension, the average investor tries to get the timing right and hopes to make his own small fortune. Unfortunately, most lose out on this.

In order to see the problem with the above reasoning, one only needs to generalize it to everyone. Every single person in the market is there to make money. So everyone is trying to buy low and sell high. So if you think that the prices are low and buy a stock, someone else MUST think that the prices are high and hence is selling to you. Who is right? Typically, there are a large number of banks that do most of the trades so the changes are that the person who is selling to you is a large bank with dedicated analysts and trader who have put in much work into guessing whether the prices are high or low. So they are more likely to be right. Hence the average investor is likely to lose.

Information

In fact, there is a very different way to look at how markets function. Trading profits can be viewed as rewards for information. In other words a person who knows something new that the market does NOT know (like the fact that a certain company is going to win a large contract) can use this information to make a profit (for instance by buying stocks of the company and waiting till the information becomes public). Unfortunately, it is VERY difficult to know what the market knows and what it does not. Someone else may have known about the contract and he may have purchased a large amount of stock leading to increase in prices so even after the news becomes public (and the other person sells his stock) there is no significant increase in prices.

The question that every investor must ask himself is - whether he really has some information that the market does not have? Typically the answer would be no.

Investment v/s Trading

A person who makes money in a short time from new information is a trader. One who has money and time but no information is an investor. An investor must not expect "super normal" profits (which a trader does); if he does so he will likely have losses.

So now the question is - what should an investor do? An investor must stay clear of trader; since this is not really possible, the idea is to never invest in one stock at one time. Instead,

1. Invest in a basket of stocks
2. Invest over a period of time

The above two ensure that positive and negative effects balance each other leaving the investor with normal profits and minimum risk. The above two directly result in the concept of a SIP.

Practical Advise

1. Get a demat, trading and netbanking account so that you do not have to rely to brokers and intermediaries. The cost of the accounts is trivial.
2. Figure out a good mutual fund. A good mutual fund is one that has low management fees and follows a broad index rather than trying to be "too smart".
3. Figure out the total money you want to invest over the next year or so.
4. Start a SIP with monthly investments that are roughly one twelfth of your yearly target using you r trading account.
5. Bonus - If you feel that the SIP fees are too high (typically 100-150 Rs), you can save the same by manually making the trade on the pre-decided date every month.

Traditional Insurance

History

In the Indian context, traditional insurance refers to the popular plans by originally started by LIC that combined savings and insurance. These are typically sold by a freelancer agents who get a (pretty hefty - around 25%) commission for each plan they sell as well as a (small - 1-2%) commission each time the customer pays a renewal premium. Originally these were the only alternative to Post Office schemes (NSC and Kisan Vikas Patra) for a large number of Indians. This, together with the network of LIC agents is probably what accounts for their popularity.

Issues

I am highly suspicious of products that have a large commission because I find that the commissions are rarely justified for an informed investor. This is what makes me most skeptical of traditional insurance policies. At a minimum, these result in a lower yield for the investor.

The other major reason is that there is no good reason to club insurance and investment. Clubbing the two typically only results in opaqueness - it is not clear how much of the premium goes into insurance and how much into investment making it difficult to compare with other options. Often, this is used to mask the actual returns be-fooling the investor.

Analysis

A typical plan that was sold to me had an annual premium of 24,000. The insurance provided was Rs 5 Lakh. An online policy that would typically provide an insurance of 50 Lakh at an annual premium of around Rs 8,000. So we can assume that premium for Rs 5 Lakh would be Rs 800. This means that 23,200 goes into investment.

This plan gave 75,000 every 5 years and 5 Lakh on maturity. Other returns were unclear; there would be some bonus depending on the performance of the fund. I have seen a bonus of 8 Lakh at times for similar schemes. Thus the rate of return varies form 5-10%. It is here that opaqueness comes into play. We have no idea what the risk is; whether it is tied to markets (and which ones) so that the same can be hedged. We have no certainty regarding how much money we will get so it makes planning difficult.

The largest issue, however, is that these policies are VERY illiquid. Often if you stop paying the premium after 2-3 years, the policy lapses and you do not get any return. I know a large number of people who suddenly had increased financial commitments forcing them to stop paying premiums. Many of these people suffered losses to the tune of 50,000 to 1,00,000.

Alternatives

Fixed deposits would be very safe but would give a pre tax return of 8-9%. For people in the lower tax brackets, this would easily beat the traditional insurance policies. On the other hand, mutual fund investment over a 25 year period is likely to be as risky as the traditional insurance plans but would probably give 12-15% tax free.

Lastly, I would strongly recommend everyone to buy a term life plan to take care of the insurance needs.

ETFs

Introduction

I love ETFs. They are my preferred financial instruments of choice. And within ETFs, I prefer index funds. I prefer purchasing ETFs via SIPs - both ICICI and HDFC trading accounts allow that for a pretty small fee.

Terminology

• ETF: ETF is short for Exchange Traded Funds. These are just like mutual funds with one major advantage - in mutual funds, you can only sell back the units to the fund. In ETFs, these units can be bought and sold in the market just like any other stocks. Further derivatives (options and futures) on ETFs are also available and can be bought or sold.
• Active strategy: An active strategy tries to increase returns by trying to time the market - basically buy when the market is low and sell when it is high.
• Passive strategy: A passive strategy is a simple buy and hold. A basket of shares is created and then it is held for a long time (often several years) without any changes.
• Index: An index (like the BSE Sensex or the NSE Nifty) is basically a basket of stocks in a certain ratio. The index value is basically an average of the prices of the stocks weighted by the ratio in the basket.
• Index funds: These are mutual funds that track a certain index. In the best case, they purchase stocks in the same ratio as the index. Often, however, they purchase a subset of the stocks in a different ratio but these are so chosen to closely monitor the index.
• SIP / SEP: A SIP is a systematic investment plan while a SEP is a systematic equity plan. Basically these involve buying a small amount of stocks of units every few days (or every month) rather than all at once.

My reason for preferring ETFs are that they combine high returns with low hassle and good liquidity. Readers of my earlier post on liquidity will understand why it is so important. Unfortunately, it is very difficult to combine liquidity with high yields. Index fund ETFs are the closest that we get to the ideal.

Returns

First, let us look at returns. Elementary finance teaches us that the best risk-return ratio belongs to index funds - basically nobody can beat the market. Why that is so is the subject of another blog post but take it as gospel for now. This gives us the following rules of thumb

1. Mutual funds are better than individual stock.
2. Market index funds (like Nifty) are better than sectoral funds.
3. Passive strategy is better than active strategy.

The first is obvious since individual stock prices vary very much and so are risky. The second is a simple corollary. The third is surprising because EVERY mutual fund will say the opposite. What they do not tell you is that the charge for active strategy are high than for passive strategy so they have a vested interest in be-fooling you.

My preferred ETF - the NiftyBees (by Goldman Sachs) has an annual charge of only 0.5%. By contrast most mutual funds charge between 1-2%. Over a 20 year period, this itself will result in a 12-40% difference in returns.

Liquidity

Since ETFs can be traded, you can sell them via a trading account and get the money in 2 days. Hence, in case of an emergency, you will have cash in 3-5 days. Further, since they are index funds, you will not lose significantly due to market volatility.

Hassles

If you have a demat account, a trading account and a netbanking account, starting ETFs is a 2 minute job once you have decided on the ETF and amount. I suggest investing via SIP / SEP You just need to log into your trading account, go to the section on SIP / SEP, enter the ETF, the quantity and frequency and press enter. Every month, the set amount of units will be purchased and your netbanking account debited with the money.

Liquidity

This is the most important thing to take care of while planning your finances. Simply speaking liquidity is the ability to convert your assets into money.

This is very important especially in emergencies. The reason is simple - a large number of problems can be solved by ready cash. This is more important for people in their first few years for various reasons. One is that they have settled into a rhythm and so "unexpected" expenses suddenly crop up. Second is that often people have a lot of responsibilities and hence they need money to fulfill them.

Scenarios

Lack of planning

I remember that in my first year after marriage, money was chronically short. The reason was not that my I was a spindrift (nor my wife for that matter). It was just that there a number of expenses that we had not accounted for. We would forget to pay some of our bills in time. The rent would have to be paid and suddenly our account would be empty. Just after getting the salary we would feel that we have a lot of money and hence would splurge on capital items like washing machine and AC.

Sure, we could have planned better but I think this is a problem that everyone of my friends faced. It seems that planning requires experience and at this stage everybody lacks it so it simpler to just have some cash at hand (or in the back).

Commitments

One of my friends was very happy after getting a job. Just before filing his first tax return, he got an expensive insurance policy to save tax. Unfortunately, the policy would give him no money for the first 10 years while devouring a significant chunk of his savings. Unfortunately he had a lot of responsibilities - getting three of his sisters married over the next five years. In this scenario, the insurance policy made no sense. The main problem was that the policy was not liquid - it could not be converted to cash when required. My friend would have been better off paying the tax - he was in the 10% bracket.

Liquidity is higher when it takes less time to convert to cash AND when the penalty for coversion to cash is less.

Basic rules of thumb about liquidity

1. Cash and money in savings account are the most liquid
2. Fixed deposits and funds in money market funds are very highly liquid - these can be converted to cash in less than a day and have a low penalty.
3. ETFs, stocks and other instruments in demat account are next - these can be converted to cash in 2-3 days but because of market fluctuation, there may be loss
4. Mutual funds, ULIPs and some insurance policies - These often take one to two weeks to convert to cash as there is paperwork involved. Further, there may be substantial loss depending on the terms and conditions.
5. Property - this can often take months to convert to cash and may involve significant loss in case of distress sale
6. Retirement funds, PPF, EPF, most LIC policies, NSC - These are often nearly completely illiquid - they can not be disposed of before a predefined period which ranges from 5-30 years.

Conclusion

Given the above, my sense is that people should get a netbanking, demat and trading account and invest in FDs and ETFs till their early responsibilities are over.