Tuesday, October 16, 2012

5 investment robbers, and how to deal with them

As an investor you may face different types of challenges in the current global environment where markets and investments are linked. As a fund investor, your life is even more complicated when you have to select between myriad funds from various fund houses. There are several investment options you have among funds—open-ended or close-ended, equity, debt, or commodities, etc.

Having said that, what is the best fund that meets your investment target and needs? Rather than looking at the positives of each fund, let us take a look at the different “investment robbers” and how each fund protects and guards you against each of these robbers.

A fund which protects you from all the “robbers” is the fund we are looking for you.

Investment Robber 1: Inflation

Inflation is one of the biggest—and silent—enemies of any investor, a monster that many investors fail to recognize. Many people believe in “saving money” and mistake it for investment. However, saving is not investing – not according to the rules of money at least.

The rules of money permanently changed in 1971 when the then US president Richard Nixon took the country off the gold standard—a monetary system in which the standard economic unit of account is a fixed weight of gold—and granted itself the license to print money. Since then the US dollar and other world currencies have depreciated while the prices of all commodities measured against them, be it precious metals like gold and silver, industrial metals like steel, copper and aluminum, or agricultural commodities—have all gone up and will continue to rise over the long term.

Hence, inflation is the primary evil that a fund has to protect your investments from.

Debt funds do not offer any protection against inflation because bonds and money market instruments primarily invest for coupon interest or accrual, neither of which is capable of protecting your money against currency depreciation due to inflation. These investments only offer current income, not growth income.

Equity funds certainly offer you protection from inflation as they are invested in companies whose earnings are supposed to grow. Also, gold funds will offer you protection against inflation.

Investment Robber 2: Income Tax

The government is the biggest investment robber, one which systematically takes away your money at all dealing stages—savings, spends, investment or insurance. The tax authorities usually leave a large dent in your pocket. For example, the interest on a bond is fully taxable. As far as mutual funds are concerned, all debt products are taxed and, hence, pure debt funds are helpless at protecting you from taxes.

Equity funds offer you protection in the form of tax-free dividends and long-term capital gains exempt from the purview of the taxman.

Investment Robber 3: Interest Rates

Interest rates are very dangerous in that they affect both debt and equity investments. When interest rates rise, bonds prices fall and so does the net asset value of your bond fund. Again, when interest rates rise, equities as a general rule fall because the earnings of companies drop due to the high finance and interest costs and a contraction in equity valuations due to an increase in discount rates.

Gold investments are what will help you fight off the interest rate demon.

Investment Robber 4: Market Volatility

Prices of all market-determined products, be it equities, bonds or gold, will fluctuate day-to-day. Yes, the price of an accrual product, like a liquid fund, will certainly protect you against market volatility but not against inflation, income tax as well as incorrect asset collection.

Investment Robber 5: Incorrect Asset Allocation

The importance of asset allocation can be understood by only one statistical fact which, Roger Ibbotson, chairman and chief investment officer of equity investment and hedge fund manager Zebra Capital Management, and a professor in finance at Yale University, and Morningstar's Paul D. Kaplan showed in a study in 2000 that 90 per cent of portfolio variability is due to asset allocation. This means only 10 per cent of the variability in portfolio performance is due to individual holdings.

In his book ‘Intelligent Asset Allocator’, American financial theorist William Bernstein has said that “there are two kinds of investors: those who do not know where the market is headed, and those who do not know that they do not know. Then again, there is a third type—the investment professional who indeed knows that he does not know, but whose livelihood depends on “appearing to know”.

Therefore, a cardinal principle of investment is that the only thing which is under your control is asset allocation because that is what you have full control over. However, equity, bond or gold funds do not offer you protection against incorrect asset allocation.

Then what does? Read on.

The panacea is a ‘balanced fund’. Let us see how a balanced fund indeed protects you from all different investment robbers.

Inflation: Balanced funds invest both in equities and debt. The equity component guards your investment against inflation.

Income Tax: Balance funds are treated as equity funds for taxation purposes and, hence, its dividends are tax free as well as outside the purview of long-term capital gains tax. The beauty of it is that even the debt portion becomes tax free, which never ever happens in any other case.

Interest Rates: These funds invest in both equities and debt. The equity component will help you thwart off interest rate troubles.

Market Volatility: Since these funds invest in both equity and debt, they even out-market volatility by providing you with the best risk-adjusted returns with minimal market volatility.

Incorrect Asset Allocation: This is perhaps the most important protection offered by balance funds. As explained earlier, the key to a long-term superior investment performance is asset allocation and what can be better than a fund which has allocation in both equities and debt? Further, these funds always buy the cheaper asset and sell the costlier one when one asset class outperforms the other for optimal asset allocation. This actually is the most important principle of investment—buy cheap and sell dear.