Investors are swamped by a variety of products and advice in personal finance. However, mass-customisation is impossible for rendering effective personal financial advice. As a result, investors are often overwhelmed with products and advice with very little perspective on their utility to their own individual financial situations.

Evaluate objectives

The first step of a financial planning exercise is to evaluate the objectives and risk tolerance of an investor. It is usually observed that investors often start with the products tailoring their plan around them. It is like a tail wagging a dog as products should be serving the objectives and not the other way round.

Financial products

Contemporary financial products menu includes real estate, equity, bonds, insurance, gold, commodities, and alternatives. It is important to classify these asset classes into two primary categories: wealth creating and wealth preserving. This distinction is important to remember as these divergent objectives often get mixed up mostly due to clever product packaging. Of the choices currently available in India, only real state and equity qualify as wealth creators while gold, bonds and alternatives must be employed to preserve wealth.

Real estate

Real estate can create wealth if it is viewed upon as an investment. Self-occupation on the other hand transforms real estate from a wealth creator to a preserver. However, self-occupied real estate has come to occupy a lion's share of savings for a common man that portends a real risk as self-occupation produces an income only equivalent of savings on rent. In most of urban India, rental yields do not exceed 3%. Buying an expensive property for self-occupation is equivalent to investing a major chunk of your savings at 3%. Capital appreciation is not applicable in this case as the intention is not to sell it but to stay in it. This is one of the most popular forms of misallocation of capital. It will result in a great property and a stretched financial condition for the owner with grave consequences for other equally important goals such as child's education and a decent retirement kitty. The worst part of self-occupied real estate is that with each passing day, as the property value rises, it becomes increasingly difficult to divest it. A better solution is to either buy a property as an investment with a clear timeline to divest or to buy a smaller house than you currently live in so that one blocks as less a capital as possible in order to free up capital for more productive uses. As a rule of thumb, a home for self-occupation should be bought with as much equity as possible to guard against the vagaries of the economic cycles with sufficient capital left to meet other objectives.

Equity

Equity unleashes the power of compounding to beat inflation over long periods of time while long-term capital gains exemption is the icing on the cake that makes it the best wealth creator in its class. However, ample caution must be exercised in selecting the right stocks and tracking them diligently. If selection and tracking stocks seems to be challenge as many investors have discovered over the past five years, investing in any benchmark (Nifty) indexed fund should serve the purpose of beating inflation by investing in equity as the indices have a survivorship bias which helps them weed out the duds from time to time.

Gold

Gold is another popular investment choice for many Indians. Widely perceived as a wealth creator by a vast majority of Indians, it is at best a wealth preserver. A large part of the gains in gold prices that Indians witnessed for 30 years in the period 1980 to 2009 was on account of depreciation of rupee against the USD and not because of any real appreciation in the value of gold. Buying gold in the form of jewellery leads 15 to 17% cut in value on account of making charges and various government duties that are difficult to recover in resale. Gold should ideally be viewed as portfolio insurance and allocations should be restricted to less than 10%.

Tax planning instruments

Tax planning instruments such as insurance should not be viewed as a proxy to financial plans. Tax planning should not dictate financial planning because the objective of tax planning is to minimise tax outgo while a good financial plan aims at maximising the post-tax income.

Bonds

Bonds and alternatives over a period of time, if properly employed, can act as wealth preservers. However, investors must be wary of trying to time the bond market too often to derive capital gains. It is no less treacherous than trying to time equity markets as many investors discovered a few months ago when the consensus bond trade went hopelessly wrong.

Fixed maturity plans

Investing in fixed maturity plans (FMP) might be a better idea to meet the objective of asset allocation while deploying some part of short-term liquidity in liquid funds is an idea worth implementing. While bonds are tax-efficient compared to bank fixed deposit, investors must be cognizant of the interest rate risk and default risk prevalent in bonds. While interest rate risk can be mitigated by holding the bonds to maturity, investors must be cautious to the prospect of default risk in a high yield bond.

Alternatives

Alternatives (mostly hybrid structures involving multiple asset classes) on the other hand while originally designed for wealth preservation during uncertain and volatile times have been distorted to give an impression of the great new "risk-free" invention of modern finance. A contemporary fad, they deliver an immense intellectual fulfilment to both the buyer and the seller of such structures almost to the point that risk in these arcane structures is never discussed. Scenario analysis and understanding risk of such structures along with their utility and impact on the financial plan should drive the decision instead of projected returns.

Financial planning

Financial planning should lay emphasis on diversification in at least 3-4 asset classes because the long-term objective is securing risk adjusted returns that are consistent even if moderate. In this regard, the past performance of any asset class should not blind the planner to its risks as it is often observed that the best performing asset classes have an extraordinarily large share in the portfolio. Such a strategy more often than not backfires with painful consequences for the investor.

It is also important for investors to participate in the process of financial planning right from the selection of the planner to the decisions taken in their portfolio. It is entirely possible that the investors may not comprehend the details of investing but it should not stop them from asking questions. It will help them learn and at the same time keep the financial planner on her toes. However, it is of late being observed that investors are increasingly delegating all the decisions to their advisers. It is good that you trust your adviser but you should always remember that wealth management is a collaborative process and unless you participate enthusiastically, chances are you will be disappointed with the outcomes over a period of time.

The author is Chairman-cum-Managing Director, Angel Broking. The views expressed in this article are his own

Our new client who came in for financial advice mentioned the loss he made on his mutual fund investments of Rs 15 lakh. He had made systematic investments in equity mutual funds as per the advice of his earlier financial adviser. While going through his profile, we noticed he also had a home loan of Rs 75 lakh which he had taken about 3 years ago and apart from knowing that his monthly EMI was around Rs 74,000, he had no idea about the loan amount still outstanding and the interest rate he was paying. He was vaguely aware that his lender had increased interest rates but was not sure about the rate being charged to him. A little digging showed us that he was now paying 12% interest and the only reason he was not aware of this was because the lender had kept his EMI same and just increased his loan tenure.

It was shocking that such an aware investor was totally oblivious to the cost he was paying for his home loan. Acting on advice, he spoke to his existing lender and got substantial rate reduction without any cost.

But it set me thinking. Investment is an activity that makes you a more active participant in the process which is missing even though you may be paying an enormous percentage of your monthly income as an EMI on your home loan. As long as the amount does not change, you are oblivious to the cost you are paying even though you are vaguely aware that you are paying more than what you should be paying.

Let me ask you? Do you know the interest rate that you are paying on your home loan? Believe me very few people know the actual interest rate they are paying on the home loan. When the same question is asked among a group of mutual fund investors who invest through SIP — a significantly higher number were aware of the returns that they are getting on their mutual funds. So there is this strange dichotomy between SIP investments and loans, though in both cases the instalment is debited to the bank account automatically every month. It is perhaps the voluntary nature of SIP payments (which can be stopped at any time without any penalty) and the fact that the interest rate is not visible in the EMI that causes this. There is no immediate pain when the interest rate on your home loan is raised since the EMI remains the same. You tend to ignore the communication (letter/email/SMS) that you receive informing you about the rate increase (now mandatory as per regulations).

Banks started this practise of increasing tenure rather than EMI from practical considerations because repayments are being made by post-dated cheques and getting fresh post-dated cheques as replacement for the old cheques is a Herculean task. When the repayment mode shifted to Electronic clearance system (ECS), the practice just continued.

Whenever banks have been forced to increase EMIs due to the quick increases in interest rates in the past (despite the costs involved) they have seen increased consumer activity to shift their loans to cheaper lenders. And it is always the better profile consumers who shift their loans to competition.

Both the regulators — RBI and National Housing Bank (NHB) - have acknowledged the pernicious market practice of Indian lenders to charge higher rates to existing home loan consumers while providing lower rates to new consumers. The regulators were forced by public opinion to ban the charging of pre-payment charges to provide some respite at least to the more aware and active consumers. Now they can do more by mandating a change in the default option when interest rates of the lenders change - the default option should be to change the EMI amount due to change in interest rates. This is good for lenders as well since tenures will not elongate (thereby increasing credit risk for the lender) and as the consumers will be signing the ECS mandate for larger up to limits, they are likely to be sensitised to the fact that EMIs can rise as interest rates rise. Of course consumers can always talk to the lenders and revert back to keeping the EMIs the same with change in tenure. And if the rates reduce, they will actually see more cash in their hands because of reduced EMIs.

The author is CEO, Apna Paisa. The views expressed in this article are his own