Careful mistakes you make!!

MISTAKES can be expensive. Ask the guy who looked at a beautiful girl crossing the road instead of looking at the car in front of him. His glance cost him over 1 lakh (Rs 100,000) in damages. But you could argue that this was a careless mistake. But what about the mistakes we make carefully?

Careful mistakes are the ones we make after long deliberation, wrong calculation leading to the wrong choice. And naturally these cost you more. Lets look at Insurance for instance.

Firstly, we need to be a clear about one point — Insurance is a cost. Whether one would want to incur this cost or not, and to what amount, is a matter of personal choice. And since it is a cost, the obvious thing to do is minimize the cost without sacrificing the basic life cover.

The big mistake
This is where the big mistake comes in: Pure-protection policies, where one doesn’t get anything back if one survives the policy term, are the ideal choice for the above objective. But psychologically, it is difficult for people to pay-up hard cash for an intangible product, ie security. So they go in for insurance products with returns.

Hence, moneyback and endowment (and of late Unit Linked Insurance Plans or ULIPs) type of policies are taken. But this is what they forget:

• The same amount that they would otherwise pay in a term policy also gets deducted from these so-called protection and investment policies. And only the net amount gets invested.
• The administrative costs are high
• Corpus is invested in very safe instruments
• Therefore, the returns from such policies are usually very low — usually in the range of 5-7% pa.

Naturally, a person would be better off taking a term policy to get the life cover and investing the balance premium amount say in PPF where he can earn 8% pa returns (assuming he wants no risk of investing in equity, where the returns can be much higher).

The mass exodus
As more people realise their mistake, they want to exit from such insurance policies. Unfortunately, early exit from insurance policies results in a huge loss. So does it make sense to surrender one’s policies despite this loss? There could be three broad scenarios possible, depending on how many premiums you have already paid, out of the total premiums payable.

• Early stage: A policy can be surrendered only if it has been in force for three years and premiums have been paid for these years. If you have paid just one or two annual premiums, then you will get back nothing when you exit from the policy. Even thereafter, you will get back say only 25-35% of the premiums paid + bonus accrued, if any. This is for a typical 20-year term policy. The % varies depending on the term and premiums paid.

Now, if you invest this amount + the future premiums in other investment options, you will need to generate around 9-11% p.a. returns to recover the lost premiums and break-even with the insurance policy if you had continued with it.

If you’re confident take a hit and move on!

• Middle stage: If you are somewhere around the middle of the policy, you can either surrender the policy by taking around 50% of the premiums paid + bonus; and invest this and the future premiums somewhere else. But remember that the absolute loss is higher here as more premiums have been paid and time for recovery is less. So, you need to generate maybe around 14-17% pa returns to break-even.

Optionally, you can make the policy fully-paid. Your sum assured will be suitably lowered. And you will back the premiums paid + bonus earned — but only at the end of the original term. Also no fresh bonus will accrue during this period. The net return for this amount works out about 4%. Invest the future premiums in the other options. Here you may have to generate somewhat lower returns of around 12-15% p.a. to break-even on overall basis.

• Late stage: If your policy is just about to mature in three to five years, then it may well be prudent to let it run its course. You can’t do much by saving 3-5 years’ of premium payments.

These are only broad numbers purely for indicative purposes. It’s important that you do a detailed working for each of your policies, before taking any further action.

But, with a GDP growth expectation of 7-10% over the next decade or so, the returns outlined are pretty reasonable especially if you choose equity. If you have the capacity for a little risk, go ahead. After all, there’s no gain without pain right?

Author: Sanjay Matai
Source: Wealth, MoneyControl

New fund offers, worth the money?

WE’RE all familiar with the phrase ‘Make hay while the sun shines’. Apparently the financial world is also familiar with it because that would explain the slew of mutual fund new fund offers (NFO) due to the buoyant mood of the markets.
And because we all love new things, investors have rushed to redeem their crores from a perfectly well performing existing fund to invest an NFO with similar objectives.

But how smart is that? Mutual Fund NFOs are nothing but commencement of a new scheme. They should not be confused with equity IPO usually get huge listing gain. There is no such upside on MF IPO’s. In fact there very well may be a downside. Lets look at it closely:

1. Ignorance is not bliss
One of the major reasons for the success of mutual fund NFOs has been the continued ignorance of an average investor with regards to the NAV. They have all along assumed that if they are getting the units at par ie Rs10, they are getting it cheap. Huge error!

NAV merely represents the market value of the portfolio. It is the book value. Thus when one invests in a mutual fund one is buying the units at the book value — which is Rs 10 for a NFO and could be Rs 15 or Rs 20 or whatever for an existing scheme.

The NAV of an existing scheme is higher merely for the fact that its portfolio has appreciated since the time it built it’s portfolio. Going forward, the returns over a given period of time will be same from an existing portfolio (with a higher NAV) and an identical new portfolio (with Rs 10 NAV). The earlier appreciation of the old fund does not make it expensive vis-à-vis an NFO.

2. Let’s talk numbers now
Say a fund (Old Fund) was launched in Sept 2004. It raised a corpus of Rs 1 crore and allotted 10 lakh units at Rs 10 each. The corpus of Rs 1 crore was invested equally ie. Rs 25 lakh each in Reliance, ONGC, Infosys and Arvind Mills. Over the next 1-year i.e. till Sept 05 all these share prices appreciated and the corpus became Rs 1.49 crores. Accordingly the NAV of Old Fund now is Rs 14.9608.

Now, assume that in Sept ‘05 a NFO is launched. It raises Rs 1 crore and allots 10 lakh units at Rs 10 each. It also invests in the same 4 shares viz. Reliance, ONGC, Infosys and Arvind Mills. The amount to be invested in a particular share is in the same % as in the Old Fund now (This is important, as we have to compare the impact of NAV on the returns and not the impact of the portfolio).

Now we invest Rs 10,000 each in Old Fund and NFO. In Old Fund, we get 668.414 units at Rs.14.9608/unit. And in NFO we get 1000 units at Rs 10/unit.

After one year in Sept 2006, due to appreciation in the share prices, the corpus of Old Fund increases to Rs 1.74 crores and NAV to 17.4669. And corpus of NFO increases to Rs 1.16 crores and NAV to 11.6751. But the investment value in both cases would have increased to Rs 11,675.

Author: Sanjay Matai
Source: Wealth, MoneyControl