Wealth Management
Content
WEALTH MANAGEMENT
FINANCE DOCTOR
Course objectives
n n n n
What is wealth? Can everyone be wealthy? Identifying values and financial goals Inflation and Quantifying goals How can I achieve my goals?
Ø Ø
Ø Ø
n
Summary
Knowing present state – organizing information Asset classes – stocks, debt, insurance, derivatives & real estate Putting it all together Implementation & Behavioural finance
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WEALTH
Passive income sufficient to sustain the desired lifestyle
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Identifying Values → Goals
n n n n
Retirement Education Housing Protection
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Quantifying Needs
RETIREMENT Visualize retirement expenses in relation to current expenses Monthly expenses Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other Current Retirement 7000 6000 4000 2500 3000 6000 8000 0 2000 5500 3000 4500 3000 2500 5000 3000 0 0
TOTAL EXPENSES
35000
30000
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Quantifying Needs
TOTAL RETIREMENT MONTHLY EXPENSES TOTAL RETIREMENT ANNUAL EXPENSES Inflation rate assumption no of years inflation factor Taxation assumption Inflation adjusted retirement requirement Inflation & tax adjusted retirement requirement Return assumption on retirement Lump sum requirement at retirement 30,000 360000 6% 20 3.21 10% 1155600 1284000 8% 16050000 FINANCE
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Quantifying Needs
EDUCATION 1 2 3 4 5 6 7 8 9 10 children's names Kavi Deepika ages 1 0 7 no. of years until univ. 8 11 estimated no. of yrs in univ. 4 4 no. of years for infl. Adj. 10 13 estimated annual infl. Rate 6% 6% inflation factor 1.79 2.13 est. annual univ. cost today 200000 200000 est. annual costs adj. 358000 426000 estimated total costs adj. 1432000 1704000 money reqd. 2013 2016 I N A N C E F
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Quantifying Needs
HOUSING 1 present value of the house 2 down payment 3 Soft loan from the company 4 Home loan reqd. 3 EMI 4 no. of years reqd. 5 House rent allowance and taxation benefit 6 Net monthly cash outflow 2500000 500000 1000000 1000000 Rs. 945 per lakh- approx. Rs. 9450 per month 20 years Rs. 4450 per month inflow Rs. 5000
assuming housing grows at 7% for the next 20 years money required to buy comparable house Rs. 97 lakhs
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Quantifying Needs
TIMELINE
Need Money reqd. Year Education 14.32 lakhs 2013 Education 17.04 lakhs 2016 Housing 97 lakhs 2025 Retirement1.605 crores 2025
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Organizing InformationScore card
INCOME
ASSETS
EXPENSES
LIABILITIES
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Income
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other COMBINED INCOME Deductions Taxation Pension Contribution any other
NET INCOME
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Expenses – Latte factor
EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
TOTAL EXPENSES
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Liabilities – Debt management
LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets
TOTAL LIABILITIES
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Assets –Most powerful
ASSETS Liquidity Safety 12 mths basic expense short term deposits liquid funds current income bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery
Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS
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SCORE CARD
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return 50000 3% 0 0 150000 0 1250000 0 0 150000 300000 150000 0 0 0 0 0 0 100000 2150000
As Is
7%
8%
55000 15000
5% 3% 15%
6%
4%
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
40000 7000 4000 3000 8000 2000 3000 3000 5000 0
0 0 0 0 0 0 0 0
TOTAL EXPENSES
35000
TOTAL LIABILITIES
FINANCE 0 DOCTOR
If ‘As Is’ continues
1 Education 2013 -----14.32 lakhs Saving scheme-1.5 lakhs at 7% Fixed`deposit-1.5 lakhs at 5% insurance inv. 1 lakh at 4 % for 8 years Total 2 Education 2016 ------17.04 lakhs stocks-1.5 lakhs at 15% 3 Retirement 2025----- 1.6 crores monthly savings Rs. 15000 in PF at 8% monthly savings 5000 in deposits at 5% Total 4 Housing 2025------97 lakhs provident fund 12.5 lakhs at 8 % 5 Protection----- 50 lakhs presently minimal cover 2.6 2.2 1.4 6.2 lakhs lakhs lakhs lakhs
6.98 lakhs 88.4 lakhs 23.1 lakhs 1.11 crores 58.2 lakhs
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Things can be different
n
Higher returns are possible at minimal risk and make significant difference
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Power of Compounding
n
For example, if 12 lakhs is required for children s education in 10 years:
Rate of Return 6% 15% 18% Monthly saving Rs. 7322 Rs. 4367 Rs. 3622
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Power of Compounding
Time / Annualized returns 15 years 20 years 8% 15%
29 lakhs 49 lakhs
56 lakhs 1.25 crores
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Inter Relationships
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Pension Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
TOTAL EXPENSES
TOTAL LIABILITIES
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Asset QuadrantAllocation is the key decision
Maximizing wealth within business cycle & personal cycle constraints
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Personal Cycle
Accumulation stage Transition stage Reaping stage
n n n
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Personal Constraints
Liquidity Safety Current income
n n n
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Assets –Most powerful
ASSETS Liquidity Safety 12 mths basic expense short term deposits liquid funds current income bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery
Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS
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Business Cycle
Consists of economic expansions followed by contractions and revivals which merge into the expansion stage of the next cycle
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Business Cycle Stage & Asset Allocation
n
n
n
Stocks will be the best assets in certain phases of business cycle Bonds will be the best assets in certain other phases Commodities might thrive in certain other conditions
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Asset classes
n n n n n
Equity / Stocks Debt Insurance Derivatives Real estate
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What is stock?
Two major types of financing n Debt – Borrowing & lending n Stocks – Ownership
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STOCKS
Asset class with best returns and low risk – therefore most important for Wealth Creation
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Total Nominal Return Indexes, 1801 – 2001
Stocks $8,800,000
Bonds $13,975
Gold
1801
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$14.38
Comparative Indian Returns (As of 30-06-2005)
CATEGORY
COMPOUNDED ANNUALISED RETURN 1 YEAR 2 YEAR 3 YEAR 5YEAR
Stock Fund Debt Fund Fixed Deposits
74.83 4.42 5.0
72.83 4.58 5.0
61.64 7.87 6.0
40.57
6.0
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Low Risk
Price
Time
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International Experience for Stocks
n n n
USA Germany Japan
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What explains the consistency of worldwide stock returns?
n n
Related to economic activity Corporate sector is the engine of economic growth
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Risk Profiling
n
Can lead to erroneous allocation, to be used carefully
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Market Timing
Should we be always invested in stocks?
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Yes, except when stocks are severely over valued and when personal constraints are present
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Bluechip fund
Worst possible time to invest in stocks
n n n
22nd February, 2000 – NAV 30.78 17th September, 2001 – NAV 15.02 10th June, 2005 – NAV 64.23
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Returns
n n
Dividends Capital gains
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Risks
n n n
Company specific Sector specific Market level risk
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Valuation
n n n n
P/E P/B Dividend Yield Market Value/GDP
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Valuation Example
Date Sensex LevelPrice/Earnings rice/Book Dividend Yield Verdict P Subsequent Move Historical range 11-29 1.9-4.1 0.95-2.4 Feb 2000 6200 28 3.98 1 overvalued Big downward move for 3 years Dec 2002 3400 14.37 2.24 2.18 undervalued 125 % returns in year 2003 August 2004 5200 15.38 2.88 2.24 undervalued move up significantly Expected to
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Indian Equity Markets Strong long term potential
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Advantage Asia
Mixed economic data out of US, Europe and Japan. Concerns remain on structural imbalances, especially in a high oil price and inflation scenario US is unlikely to be the world s sole growth engine, given the gaping current account deficit and low savings rates. Multiple growth engines are likely to emerge with the Asian region in particular leading the way Changing demographical profile favors developing countries as developed countries are saddled with an ageing population
Asia remains relatively insulated in an uncertain environment
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Global Scenario- Growth in Brics
Goldman Sachs: Over the next 50 years, Brazil, Russia, India and China (BRICs) could together be larger than the G6 countries by 2039. UBS : By 2030, the combined purchasing power of China's and India's consumers will be five times greater than that of today's United States Growth economies driven by domestic demand offer superior investment opportunities and have a better chance of attracting new capital Global companies across sectors are looking to cut costs and improve efficiencies by outsourcing
China and India offer an unique advantage of low cost outsourcing and a vast domestic market in a world of scarce growth FINANCE DOCTOR
2010 - 2030 : Favourable Demographic Bulge
India Demographic Profile (2020)
80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -60 60 -40 40 -20 20 0 20 40 60
China Demographic Profile (2020)
Age group 80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -60 60 -40 40 40 -20 20 0 20 40 60
France Demographic Profile (2025)
80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -3 3 -2 2 1 -1 0 1 2 3
Mn people
Mn people
Mn people
20 - 35 age group : 325 mn people ( ~ 25 %)
20 - 35 age group : 308 mn people ( ~ 21 %)
20 - 35 age group : 11 mn people ( ~ 17 %)
Source: CII Conference 2002; CSFB Report; UN Population Division; BCG Analysis
Female Male
Demand growth in consumer items over the next few years to remain strong
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The growth surge
70 C onsumer loans to GDP 62 60 62
Economic reform has raised product affordability through price stability Job creation in services driving creation of +200m urban consumer base by FY07 Consumer credit is just starting to reach out to next tier of towns Rising consumer aspirations reflected in high growth of cars, mobile subs Increased consumption of services such as healthcare and tourism are also spin off benefits
53 50
52 49
40
30
20 15 10 8
7
6
0 Taiwan Malaysia Thailand Singapore Indonesia Korea India Phil. HK
Source: CLSA
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Services
IT exports contributes to 3.5% of India s GDP and contributes to nearly 1% of the economy s growth Nearly 500,000 employees directly recruited by IT exports growing at a fast pace of over 30% ITES is emerging to be a larger employment generator than IT Services IT explosion creating traction in real estate of over 1 million square feet per quarter in main cities. Support facilities is an additional employment generator.
India s strength
14 Indian IT Software & Services Exports (US$bn) 12.2 12 10 9.9
8
7.6
6.2 6
4 2.6 2 1.8
4.0
0 FY98 FY99 FY00 FY01 FY02 FY03 FY04
IT exports continues to push Indian economy into a higher growth orbit
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Indian equities offer sustainable growth paradigm
India An economic superpower in the making as demographics and consumerism play out Corporate India Gaining in strength and confidence after a period of restructuring
Indian Markets Closed 2004 a volatile year on a high note as FII inflows turned robust, reflecting the vote of confidence amongst global fund managers for India
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24 22 20 18 16 14 12 10
(%)
Industry leaders are now value creators
Return on equity Value created
Current c ost of Equity Cost of Equity
8 FY97
Source: CLSA
FY98
FY99
FY00
FY01
FY02
FY03
FY04
05CL
06CL
Capex phase in the late nineties sets foundation for value creation
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Favourable indicators for investment cycle
4500 Outstanding mfg. investments (Rsbn)
Up tick in investment proposals, after 6 years of decline Capex fuelled by need for new capacity with utilization c. 90%
4000
3500
Cost competitiveness, strong balance sheets support growth with value creation
3000
Upside from step-up in spend on infrastructure led by power Concurrent investment, consumption cycle potential for +10% IIP growth
Capacity Utilisation (%) FY02 Refining Cement Steel 96 84 82 FY03 96 86 88 95 FY04 98 81 82 94 FY05E 92 82 88 90
2500
2000 94 95 96 97 98 99 00 01 02 03 04
Source: CLSA, CMIE
Aluminium Cris Infac Source: 88
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25
(%)
Domestic equity ownership on the way up?
Equity savings as % of Financial Savings
20
15
10
5 Equity savings as % of Market C ap 0 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Source: RBI, CLSA
Household savings into equities bottoming out
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Tax changes support rise in equity ownership
120 Distribution of financial savings by households (%)
Capital gains tax on listed equities cut; NIL for holdings > 12mths
100
80
10% (from 30%) for holding <12mths Dividends tax free since FY03
60
Friendly tax regime will remove a hurdle for 40 entry of many foreign funds Retail investors invest sub 1.5% of financial savings in equities Reduced yields on bank deposits (43% of savings), bonds also favor equities
20
0 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04
Currency Claims on Govt Providend and pension funds
Deposits Insurance funds Shares and debentures N FINA
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India
The bottom line
Economic future is bright
Per capita income expected to double by 2010 companies across sectors
will have cascading effect on
India could emerge as the third largest economy in world by 2050 India and China together expected to become a market 5 times the size of today s United States in purchasing power terms in 25 years
Medium to long term story strong
Paradigm shift in exports Robust domestic demand Improved efficiencies leading to higher wealth creation by Corporate India Under ownership of equity assets will lead to higher allocation in future as risk FINANCE perceptions change DOCTOR
How to invest in stocks?
n n n n n
Current valuation Comparative yields Time horizon Diversification When to take profits?
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Mutual fund Vs Direct equity
n n
n
Debate redundant Personal choice of control vs convenience Basic principles of diversification and time horizon should be followed
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What is a mutual fund?
n
Collection of money from a large group of investors, pooling it and investing in various securities, in line with the fund’s specified objective
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Equity Fund Style
Growth
Blend
Value Large Mid Small
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Types of Mutual Funds
n n n n
Diversified equity Index Tax planning Sectoral
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RANKINGS
Forward looking as compared to traditional rankings based only on past performance Criteria n Past performance n Resilience in the falling market n Risk n Stability of fund management n Investment style n Costs n Service levels FINANCE n MNC s Indian orientation
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EQUITY DIVERSIFIED PERFORMANCE
NAME 3 MONTH RETURN (As of 30-06-2005) 1 YEAR 2 YEAR 3 YEAR 5YEAR
Index HDFC Equity Franklin India Blue Chip Magnum Contra Franklin Prima
9.09 10.37 7.04 10.51 8.15
47.49 61.68 42.86 98.87 74.83
39.93 56.91 53.72 88.77 72.83
28.04 49.61 45.20 59.08 61.64
8.58 27.63 22.22 38.88 40.57
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Active Vs Passive
Active funds have outperformed passive funds by significant margin
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Bluechip Composition
Franklin India Bluechip fund jan 31, 2005 no. name 1 Grasim 2 Infosys 3 SBI 4 ITC 5 HPCL 6 Hindalco 7 Reliance 8 BPCL 9 Satyam 10 TISCO Weighted P/E % 6.5 6.19 5.9 5.5 5.4 5.3 5.2 4.6 4.5 4.2 P/E 13 36 9.3 19 9 14 12.3 12 19.5 7.6 15.5 FINANCE
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Prima Composition
Franklin Prima jan 31,2005 no. name 1 Indian rayon 2 LIC housing fin. 3 IPCA labs 4 eicher motors 5 MICO 6 goodlass nerolac 7 amtek auto 8 birla corp. 9 GE shipping 10 raymond % 7.5 6.5 5.5 4.4 3.9 3.8 3.4 3.2 3.1 2.9 P/E 26 13.3 11.2 17 17.4 14 25 18.5 4.6 10 16.4 FINANCE
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Weighted P/E
INVESTMENT TAXATION
Equity / Equity Funds n Long term capital gains tax = 0 n Short term capital gains tax = 10% n Dividends exempt from dividend distribution tax Dividend reinvestment, FIFO n Section 80C, ELSS, SIP
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Allocation for Stocks
10 lakhs to be invested: Franklin Bluechip 2 lakhs Fidelity Fund 2 lakhs HDFC Equity 3 lakhs Franklin Prima 4 lakhs
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Conclusion
n
n
Stocks are the best assets for wealth creation However these have to be utilized in a certain manner
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Debt
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Debt
Two major sources of financing n Stocks – Ownership n Debt – Borrowing and lending
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Fixed Income Securities
n
n
Debt also known as fixed income Bond is the most familiar debt security
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Bond
n
A long agreement between borrower & lender stating the terms of a loan
n n n n
Principal Interest Maturity Face value
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Characteristics
Steady instruments n Moderate returns n Providing stability under difficult conditions Bonds are wealth preservers while stocks are wealth builders
n
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Unique proposition
Low or inverse correlation with stocks Generally useful in business cycle stage where stocks are not favored Today’s example
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n
n
n
Types of bonds
Two most useful factors for categorization n Issuers and their credit worthiness n Maturity
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Types of bonds
n n
Government bonds Corporate bonds
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Yield to maturity
Yield on a bond, taking into consideration the price paid, interest to be received and the principal amount to be repaid at maturity
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Price Yield Relationship
Inversely Related
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Return
n n
Coupon payment Capital gain
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Risk
Can fixed income securities be considered risk less?
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Risk
n n n n
Credit Risk Interest Rate Risk Reinvestment Risk Liquidity Risk
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What should be counted as Debt in portfolio?
n n n n n
Debt Funds Bonds bought directly Bank deposits Small saving schemes Provident funds
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Debt & Personal Cycle
Useful for every category within asset quadrant
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Debt Fund Style
Credit Quality
Interest rate sensitivity
High
Medium
Low High Medium Low
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Types of debt funds
n
n n
n n n n
Gilt funds duration > 3 years, sovereign credit Gilt short term duration 1 3 years Debt medium term duration 3 6 years, both corporate & Govt. Debt short term Debt ultra short term (liquid funds) Floating rate fund Hybrid funds
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DEBT FUNDS PERFORMANCE
(As of 30-06-2005)
NAME ANNUALISED RETURN (EXCEPT FOR 3 MONTHS) 3 MONTH 1 YEAR 2 YEAR 3 YEAR
HDFC Gilt Kotak Bond Prudential ICICI short term DSPML floating rate Can liquid Templeton MIP
0.23 1.53 1.74 1.32 0.10 (7days) 2.37
-0.40 4.42 5.20 5.02 0.20 (14d) 9.94
2.30 4.58
8.27 7.87
0.41 (28d) 10.56 10.83
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INVESTMENT TAXATION
Debt Funds n Long term capital gains tax = 10% n Short term capital gains tax = treated as normal income n Dividends tax free in hands of investors, 12.5% dividend distribution tax
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Insurance
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Insurance
n
n
n
Financial protection against unexpected event A risk management tool, a risk transferring product Similar to option
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Low insurance penetration in India
Total insurance premium as a % of GDP is very low comparatively
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Protection & Investment
n
n
Insurance generally sold as a mixed productprotection+investment Main issue- how good is the comparative performance of insurance investment ?
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Premium
n
Dependent on probability distributions and individual factors (actuarial studies)
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Types of Policies
n n n n n n n n
Term insurance Endowment Money back Whole life Pension policies Unit linked Children s plans Riders
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Term insurance=pure protection All other policies=term insurance+investment
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Calculation of ‘Rate of Return’ on ‘Insurance Investment”
n
n
n
Reduce everything to actual cash flows Deduct term premium from actual premium paid Calculate rate of return
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With Profit Endowment
n n n n n n
Annual premium=Rs. 22,617 Payment period=20 years Expected payback=Rs. 9.4 lakhs Term premium=Rs. 1500 PMT= Rs. 21,117 Rate=7.75%
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Money Back
n n n
n n n
Annual premium=Rs. 34,123 Payment period=20 years Expected payback=Rs. 1 lakh at 5,10,15 years and 6.4 lakhs at 20 years Term premium=Rs. 1500 PMT= Rs. 32,623 Rate=5.15%
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Calculation of Rate
m oney bac k year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 c a s h fl o ws -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 605877
IRR calculation 5.15%
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Whole Life
n n n
n n n
Annual premium=Rs. 11,855 Payment period=35 years Expected payback=Rs. 8 lakhs at the age of 80 years Term premium=Rs. 1500 PMT= Rs. 10,355 Rate=less than 3 %
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Unit linked Insurance Plans (ULIPs)
n
n
Returns are much less than comparable investment products Additionally, entry costs are very high
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Pension Plans
n n n
Accumulation phase Vesting Generation of annuity returns
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Taxation
n n n
Payment-exempt Accumulation-exempt Maturity-exempt
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Taxation of ELSS
n n n
Payment-exempt Accumulation-exempt Maturity-exempt
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Overall Comparison
n n n n n
Return-inferior Risk-same Costs-higher Taxation-same Liquidity-inferior
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Conclusion
n
n
n
Insurance is tremendously beneficial product for protection But investment performance and costs are inferior to those of mutual fund Conclusion only term insurance policy should be bought till the investment performance comes up
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Estimating Appropriate Cover
n
n
n
Present income approach- a lump sum which can generate a return almost equivalent to the present income. Roughly 10 times the annual income is a good estimate In the case study, 50 lakhs will be the amount
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Derivatives & Structured Products
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Derivatives
n
n
A derivative security derives its value from an underlying Underlying can be stocks, commodities, bullion, currency & many others
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Basic Types
n n
Futures Options
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Rationale
n
n
n
Actual transaction not happening today Instead, there is an intent or commitment Origin lies in both buyers and sellers benefiting
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Oil Prices
An example of usefulness of derivatives
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Futures
n
n
Obligation to buy or sell an asset at a pre-specified price and at a pre-specified time Quantity is also determined before hand Note that this is an obligation
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Terms
n n n n
Expiration date Initial margin MTM margin Cash settled vs delivery settled
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Options
n
Options are deferred delivery contracts that give the buyers the right, but not the obligation, to buy or sell an asset at a prespecified price and on or before a specified date Note that this is a right
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Option Terminology
n
Call Option
n
Right to buy Right to sell has the right but not the obligation has the obligation but not the right
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n
Put Option
n
n
Option Buyer
n
n
Option Writer/Seller
n
Option Terminology
n
Option Premium
n
Price paid by the buyer to acquire the right Price at which the underlying may be purchased or sold Last date for exercising the option Date on which the option is actually exercised
n
Strike Price OR Exercise Price
n
n
Expiration Date
n
n
Exercise Date
n
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Derivatives in Investment Management
n n n
Hedging Portfolio rebalancing Capital protection
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Taxation
n
n
For an investor short term & long term capital gains taxation For a business loss can be set off against other business income
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Real Estate
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Real Estate Characteristics
n n n
n
n
n
Dominant role in total wealth Housing one of the biggest expenses For most people, biggest & one of the best investment decisions Decision making not based on financial aspect alone Need for shelter & prestige also gets fulfilled Bungalow occupies an important place in an individual s psyche Deewar s FINANCE Maa comparison
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Real Estate Characteristics
n n n n
n
n n
Fall back asset in unfavourable times like in rampant inflation Important role in multi asset portfolio Low correlation with bonds and stocks Versatile and multifaceted liquidity, safety & yield enhancing Holding a physically visible asset is good Financial leverage Taxation benefits FINANCE
DOCTOR
Historical Return/ Risk
Investment statistics from Real Estate and other categories of Assets 1973-1984 (USA statistics-but provide an indication about comparative return & risk) Investment Average rate of return Risk-Std. Deviation Residential Real estate 10.53% 4.44% Farmland 14.03 11.06 Business real estate 10.78 2.77 Common stocks 9.62 19.71 Corporate bonds 7.51 13.92 Small stocks 21.96 28.11
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Risks
n n
n n n
Market Risk Property destruction & cost of replacement Developer Risk, Title deeds Tenants refusing to vacate Structural flaws
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Risks
n n n n n
Changes in neighborhood quality Liquidity risk High transaction costs Loan rate risk Landlord s duties onerous
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Distinctiveness of Real Estate
n n
n n
n n
Psychological value Concentration rather than diversification Each unit is distinct Liquidity less, transaction cost much higher Ideal time horizon longer than stocks There is no exchange for uniform price discovery
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Placing Real Estate in Portfolio
NEEDS LIQUIDITY PORTFOLIO INSTRUMENTS PERCENTAGE RETURN
SAFETY
Real Estate for self-occupation
YIELD ENHANCING Real estate as an investment
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Valuation of Real Estate
n
Physical
n n n
Market sentiment n Demand & Supply When demand goes up supply might follow at a sluggish pace
n
n n n
Land Labor Material
Zoning/ Planning Laws Controlled Release of Land Stock Limited supply of suitable land in a city, FINANCE area or a compound
DOCTOR
Valuation of Real Estate
n
n n
Like for any other asset, valuation determined by income stream its ability to generate rent is an important determinant Rental yield R/P Potential for capital gain
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Financial Leverage Factor
n
Buying cash outflows
n n n n n n
n n n
Net Buying Outflow E Net Rental Outflow R R/E Ratio also very useful for valuation
FINANCE DOCTOR
EMI as determined by house prices & interest rates Real Estate Taxes Utility Payments Home Insurance Repairs & Upkeep Savings by Tax Reduction
Real Estate Cycle
n
n
Superimposed on the main business cycle are demand supply curves of a city, sub-area and even going down to the unit itself While Real Estate in general might be depressed, one house might be fetching a very good price
FINANCE DOCTOR
Gurgaon Example – Story of a Township
First Phase 1988 to 1992
n n
n n
South of South Delhi Billed as IT Park, residential, commercial & self sufficient township Attractive prices Early adopters, investors & NRIs
FINANCE DOCTOR
Gurgaon Example – Story of a Township
Second Phase 1992 to 1996
n n n n
n n
Slow release of land stock Hype about investment potential Post reforms 1992 economy Powerful real estate cycle started kicking in Low occupancy, rents remained low R/P ratio very low
FINANCE DOCTOR
Gurgaon Example – Story of a Township
Third Phase 1996 to 2003
n
n
n
n n n
Investors taking profits by selling houses Developers increased the supply, looking at high prices Slow implementation of economic reforms People (end users) started moving in House prices crashed, rents went up FINANCE R/P ratio high
DOCTOR
Gurgaon Example – Story of a Township
Fourth Phase 2003 to to-date
Economy growing at a healthy rate n Township living up to its initial potential n Multiplexes, malls, smart residential units, multinational companies, schools & hospitals coming up n Lower interest rates & booming housing loans n 8 lane highway from airport coming up Prices surging, moved by 250% in someA N C E FIN areas in 2004. DOCTOR
n
Understanding Real Estate Cycle & Valuation is Beneficial
n
n
In Gurgaon the cycle was giving strong signals in 2003 that the property was severely under valued Surprisingly the market stayed low for quiet some time, thus the opportunity was there for taking
FINANCE DOCTOR
Understanding Real Estate Cycle & Valuation is Beneficial
Other important factors are: n Motivated seller n Importance of negotiation n R/P & R/E ratios time series and comparative n Bid offer spreads very high to get information as buyer and seller n No price discovery mechanism n Multiple demand supply curves
FINANCE DOCTOR
Beneficial Role of Real Estate in Portfolio
n
n
n
Presently real estate positively correlated to stocks and negatively to bonds Flight to safety correlation with other asset classes can break easily Analytical studies show that addition of real estate to portfolio is very beneficial returns increase while risks go down
FINANCE DOCTOR
Buying Vs Renting
n n
Buying for own usage Buying for investment
FINANCE DOCTOR
Buying for own usage
n n
n n
Forced saving Yields as compared to other safety instruments is much higher Reduces the portfolio risk Tremendous financial benefit with taxation and leverage
FINANCE DOCTOR
Buying for own usage
n
Simulation example
n
n
n
Buying entailed cash outflow of Rs. 9,450 There was an inflow in terms of HRA & Taxation benefit of Rs. 4,450 With the present value of 20 lakhs & a monthly outflow of Rs. 5,000 the effective interest on home loan is less than 2%
FINANCE DOCTOR
Buying for Investment
n n n n n n
Concentration Illiquid High transaction cost Disputed titles Weak tenancy agreements Returns can be higher in other asset classes
FINANCE DOCTOR
General Principles
n n n
n
n n
Long horizon Valuation R/P & R/E Intensive macro & localized research Comparison with other asset classes Developer s track record Legal details to be sorted out
FINANCE DOCTOR
Taxation
n n
n
n
Interest on home loan up to Rs. 1,50,000 tax deductible Payment of Rs. 1,00,000 for returning home loan principal is also tax deductible Long term capital gain (> 3 yrs) taxed at 20% with inflation indexation This can be saved if gain invested in property or specified bonds
FINANCE DOCTOR
Fixed Vs Floating
n n
n
n
Precise placing of interest rate cycle is difficult Estimate broadly whether we are at the bottom, middle or at the top of the cycle Presently we have just started moving up from lowest point of the cycle Locking in a fixed rate might be beneficial for a long term loan
FINANCE DOCTOR
Fixed Vs Floating
n n n
n
9.25% floating rate-- Rs. 916 EMI per lakh for 20 years 9.75% fixed rate -- Rs. 949 EMI per lakh for 20 years Even if the floating interest rate goes up to only 9.75% in next two years, EMI will go up to Rs. 944, because the loan amount has gone down only to Rs. 96,000 Overall in 20 years in floating, the borrower might end up paying a lot more FINANCE
DOCTOR
Conclusion
n n
n n
n
Versatile & favoured asset class For own usage, owning it under more circumstances is the correct decision Effective long term investment Increases the return while reducing the risk of the portfolio Does well under unfavourable circumstances
FINANCE DOCTOR
Conclusion
n n n n n
However, when bought for enhancing yield, investor should be very careful Return could be less than other assets Illiquid with high transaction costs Concentrated Local factors need intensive research this prevents glaring mistakes while facilitating tremendous investment opportunities
FINANCE DOCTOR
Behavioural Finance
FINANCE DOCTOR
Rationality and Emotion
n
n
Every investment involves a financial commitment and an emotional commitment Rational advice, even if supported by lots of data, is much easier to take in theory than to put in practice
FINANCE DOCTOR
Behavioural Finance
Psychological Factors can thwart rational analysis and prevent investors from achieving the best results for their portfolios n Volatility of markets cannot be explained by earnings & growth Field of Behavioural Finance
n
FINANCE DOCTOR
Nobel Prize for Behavioural Finance
n
Daniel Kahneman
n
n
Prospect theory, how individuals actually behave and make decisions when faced with uncertainty Replacing theories that assumed investors maximized their expected utility or well-being and always acted rationally
FINANCE DOCTOR
Mismatch between great opportunities & actual results
Date Dec. 93 Apr. 95 Feb. 97 Feb. 00 Sep. 01 Dec. 02 Dec. 03 Apr 23. 04 May 17. 04 Oct 4. 04 NAV Market View
4.69 Introduction of Fund 10.10 Reforms progressing well 5.00 Slow implementation of reforms 30.78 Indian technology, internet, new millennium 15.02 Global melt down 23.31 Early signs of Indian corporate resurgence 51.42 Second stage of reforms, good earnings growth 56.75 India shining, NDA expected to win 43.51 Surprising election results, Sonia as PM 54.98 Reforms seen as irreversible
FINANCE DOCTOR
Investor Psychology
Date Dec. 93 Apr. 95 Feb. 97 Feb. 00 Sep. 01 Dec. 02 Dec. 03 Apr 23. 04 May 17. 04 Oct 4. 04 N A V Investor Psychology 4.69 Memories of gold going out, 1992 scam 10.10 Investor confident and gets in 5.00 Investor sells at a loss, vows never to invest 30.78 Draws up courage to get in at 25 15.02 Extremely disillusioned, sells at a loss 23.31 Remembers the past unfavorable experience 51.42 Gets in at 42 56.75 Period of happiness, expecting more gains 43.51 Unnerved by rapid erosion 54.98 Can t really understand, state of confusion
FINANCE DOCTOR
The Emotions of Investing
FINANCE DOCTOR
Follow the Crowd & Asset Bubbles
Herding instinct n Disbelief that a large group of people could be wrong n Hard to remain separate from a crowd n Social dynamics & facts n Information cascade Asset bubbles, prices overshooting what is determined by fundamentals
n
FINANCE DOCTOR
Self Attribution Bias
Taking credit for a favourable turn of events, when credit is not due n Over confidence An investor or a fund manager taking credit for high returns in the year 1999 & remaining over invested in technology stocks
n
FINANCE DOCTOR
Representative Bias
n
Too many parallels between events that seem the same but are remarkably different
n
Example: Sensex at 6000 in year 2000 & at 6000 in year 2005
FINANCE DOCTOR
Reluctance to accept randomness
n
Psychological need to know why something happens and forming a template for future events
FINANCE DOCTOR
Cognitive Dissonance
n
n
Predisposition to disregard news that does not correspond to your view Shutting out bad news
FINANCE DOCTOR
Reference Point for Judging Performance
n
n
n
Mental accounting with purchase price as the reference point Loss aversion, much more upset about losing from this reference point Holding on to losses
FINANCE DOCTOR
Anchoring
Prospect theory predicts that investors rather than realize loss, will increase their position, since stock is now cheaper than their reference point n Anchoring in their mind more important than future prospects n Investors sell their stocks much more frequently for a gain rather than a loss They run their losses and take early profits rather than the other way round
n
FINANCE DOCTOR
Myopic Loss Aversion & Portfolio Monitoring
n
n
Tendency to base decisions on the short term fluctuations in the market Frequent portfolio changes
FINANCE DOCTOR
Applications
n n
n
n
Basic factors generating returns change far less than we think Asset allocation should be based on broad factors Investment discipline adhering to asset allocation based on long term factors Getting rid of temptation to trade stocks & other volatile assets in the short term
FINANCE DOCTOR
Applications
n n
n
n
n
Diversified portfolio Looking at future prospects rather than reference point/ anchoring Avoiding averaging if future prospects are dim Non-participation in asset bubbles (by curbing herding instinct) To buy in undervalued markets even if everybody else is selling
FINANCE DOCTOR
Putting it all together
FINANCE DOCTOR
SCORE CARD
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return 50000 3% 0 0 150000 0 1250000 0 0 150000 300000 150000 0 0 0 0 0 0 100000 2150000
As Is
7%
8%
55000 15000
5% 3% 15%
6%
4%
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
40000 7000 4000 3000 8000 2000 3000 3000 5000 0
0 0 0 0 0 0 0 0
TOTAL EXPENSES
35000
TOTAL LIABILITIES
FINANCE 0 DOCTOR
If ‘As Is’ continues
1 Education 2013 -----14.32 lakhs Saving scheme-1.5 lakhs at 7% Fixed`deposit-1.5 lakhs at 5% insurance inv. 1 lakh at 4 % for 8 years Total 2 Education 2016 ------17.04 lakhs stocks-1.5 lakhs at 15% 3 Retirement 2025----- 1.6 crores monthly savings Rs. 15000 in PF at 8% monthly savings 5000 in deposits at 5% Total 4 Housing 2025------97 lakhs provident fund 12.5 lakhs at 8 % 5 Protection----- 50 lakhs presently minimal cover 2.6 2.2 1.4 6.2 lakhs lakhs lakhs lakhs
6.98 lakhs 88.4 lakhs 23.1 lakhs 1.11 crores 58.2 lakhs
FINANCE DOCTOR
Should Be
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution HRA & Taxation Benefit Monthly in Rs. 6months basic expense amount present return short term deposits liquid funds 200000 3% Safety current income generating bonds 0 saving schemes 0 real estate on rent 0 long term provident fund,pension plans 220000 8% rbi bonds 0 real estate own usage(housing) 2500000 fixed term deposits 0 5% gold, jewellery 300000 3% Yield Enhancing stocks-direct equity 30000 15% stocks-mutual funds(Education) 900000 15% bonds 0 bond funds 0 6% real estate for investment 0 commodities 0 art,antique 0 investible part of insurance policy 0 4% TOTAL ASSETS 4150000 LIABILITIES Short term credit card loan 0 borrowings on life insurance 0 personal loan installment 0 accrued income taxes 0 other obligations 0 Long term home loan principal yet to be repayed 2000000 loans to purchase investmnt assets 0 loans to purchase personal assets 0 ASSETS Liquidity
55000 3000 4450
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary Housing Loan EMI Term Ins. premium(protection)
56500 7000 4000 3000 8000 2000 3000 3000 5000 9450 2000
TOTAL EXPENSES
46500
TOTAL LIABILITIES
2000000
FINANCE DOCTOR
‘Should Be’ Adjustments
n n
n
n
n
n
n
Home for own usage bought with 5 lakhs down payment, 10 lakhs soft loan from the company and 10 lakhs as home loan from the bank Term insurance of 50 lakhs cover bought with a premium of Rs. 2000 per month Monthly savings of Rs. 13,000 now being channelized into stock funds except for the mandatory requirement for Provident Fund, both for Retirement Investible money earmarked for children s education moved to stock mutual funds Minimal money in Existing Provident Fund Account, in keeping with whatever is required by rules Liquidity component now has amount equivalent to 6 months expenses FINAN Gold & Jewellery totally as before for marital insurance C E
DOCTOR
If ‘Should Be’ Implemented
EDUCATION 1 Education 2013 -----14.32 lakhs 5 lakhs at 15% for 8 years 2 Education 2016 ------17.04 lakhs 4 lakhs at 15% for 11 years RETIREMENT 2025- 1.6 crores Rs. 10,000 every month at 15 % for 20 years Rs. 3000 every month at 8% for 20 years HOUSING 2025-----97 lakhs House worth 25 lakhs bought today 5 lakhs down payment Soft loan of 10 lakhs to be returned after 20 years, present lump sum in PF earmarked . Net outflow of Rs. 5000 every month PROTECTION insurance premium,monthly outflow of Rs. 2000 15.3 lakhs 18.60 lakhs 1.5 crores 17.6 lakhs
FINANCE DOCTOR
‘Should Be’ Asset Allocation
ASSETS Liquidity 6months basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate own usage(housing) fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds(Education) bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS art,antique investible part of insurance policy TOTAL ASSETS amount allocation % 5% 200000 0 0 0 220000 0 2500000 0 300000 30000 900000 0 0 0 0 0 0 4150000 0 0 4150000 5% 60% 7%
22%
0%
100%
100%
FINANCE DOCTOR
After 5 Years
12 mths basic expense amount short term deposits liquid funds current income generating Safety bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
40%
30% 20%
100%F
INANCE DOCTOR
Asset Allocation 25 – 30 Years Old (Accumulator)
12 mths basic expense amount short term deposits liquid funds current income generating Safety bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
10%
75% 5%
FINANCE 100% D O C T O R
Asset Allocation 40 – 45 Years Old (Mid Life Accumulator/ Harvester)
12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
30%
50% 10%
100%F
INANCE DOCTOR
Asset Allocation 40 – 45 Years Old (Mid Life Accumulator/ Harvester)
Business Conditions Change – P/E at 24, Bond Yields at 10.5
amount 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
35%
15% 40%
100%F
INANCE DOCTOR
Asset Allocation 55 – 60 Years Old (Harvester)
ASSETS Liquidity 12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS allocation % 10% 50%
20%
70%
10% 10%
100%F
INANCE DOCTOR
Asset Allocation Double Income High Liquidity
12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
15%
60% 15%
100%F
INANCE DOCTOR
Implementation
n n
Pay yourself first Automate your plan
FINANCE DOCTOR
Summary
n n
§ n n n
n
n
Everybody can be wealthy Achievable at minimal risk and with minimal adjustments Know values & specific goals Organize information & utilize score card Asset allocation is the key decision Know characteristics & general principles of various asset classes Put together a plan consistent with your objectives Automate your plan so that it gets FINANCE implemented DOCTOR
FINANCE DOCTOR
Course objectives
n n n n
What is wealth? Can everyone be wealthy? Identifying values and financial goals Inflation and Quantifying goals How can I achieve my goals?
Ø Ø
Ø Ø
n
Summary
Knowing present state – organizing information Asset classes – stocks, debt, insurance, derivatives & real estate Putting it all together Implementation & Behavioural finance
FINANCE DOCTOR
WEALTH
Passive income sufficient to sustain the desired lifestyle
FINANCE DOCTOR
Identifying Values → Goals
n n n n
Retirement Education Housing Protection
FINANCE DOCTOR
Quantifying Needs
RETIREMENT Visualize retirement expenses in relation to current expenses Monthly expenses Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other Current Retirement 7000 6000 4000 2500 3000 6000 8000 0 2000 5500 3000 4500 3000 2500 5000 3000 0 0
TOTAL EXPENSES
35000
30000
FINANCE DOCTOR
Quantifying Needs
TOTAL RETIREMENT MONTHLY EXPENSES TOTAL RETIREMENT ANNUAL EXPENSES Inflation rate assumption no of years inflation factor Taxation assumption Inflation adjusted retirement requirement Inflation & tax adjusted retirement requirement Return assumption on retirement Lump sum requirement at retirement 30,000 360000 6% 20 3.21 10% 1155600 1284000 8% 16050000 FINANCE
DOCTOR
Quantifying Needs
EDUCATION 1 2 3 4 5 6 7 8 9 10 children's names Kavi Deepika ages 1 0 7 no. of years until univ. 8 11 estimated no. of yrs in univ. 4 4 no. of years for infl. Adj. 10 13 estimated annual infl. Rate 6% 6% inflation factor 1.79 2.13 est. annual univ. cost today 200000 200000 est. annual costs adj. 358000 426000 estimated total costs adj. 1432000 1704000 money reqd. 2013 2016 I N A N C E F
DOCTOR
Quantifying Needs
HOUSING 1 present value of the house 2 down payment 3 Soft loan from the company 4 Home loan reqd. 3 EMI 4 no. of years reqd. 5 House rent allowance and taxation benefit 6 Net monthly cash outflow 2500000 500000 1000000 1000000 Rs. 945 per lakh- approx. Rs. 9450 per month 20 years Rs. 4450 per month inflow Rs. 5000
assuming housing grows at 7% for the next 20 years money required to buy comparable house Rs. 97 lakhs
FINANCE DOCTOR
Quantifying Needs
TIMELINE
Need Money reqd. Year Education 14.32 lakhs 2013 Education 17.04 lakhs 2016 Housing 97 lakhs 2025 Retirement1.605 crores 2025
FINANCE DOCTOR
Organizing InformationScore card
INCOME
ASSETS
EXPENSES
LIABILITIES
FINANCE DOCTOR
Income
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other COMBINED INCOME Deductions Taxation Pension Contribution any other
NET INCOME
FINANCE DOCTOR
Expenses – Latte factor
EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
TOTAL EXPENSES
FINANCE DOCTOR
Liabilities – Debt management
LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets
TOTAL LIABILITIES
FINANCE DOCTOR
Assets –Most powerful
ASSETS Liquidity Safety 12 mths basic expense short term deposits liquid funds current income bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery
Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS
FINANCE DOCTOR
SCORE CARD
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return 50000 3% 0 0 150000 0 1250000 0 0 150000 300000 150000 0 0 0 0 0 0 100000 2150000
As Is
7%
8%
55000 15000
5% 3% 15%
6%
4%
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
40000 7000 4000 3000 8000 2000 3000 3000 5000 0
0 0 0 0 0 0 0 0
TOTAL EXPENSES
35000
TOTAL LIABILITIES
FINANCE 0 DOCTOR
If ‘As Is’ continues
1 Education 2013 -----14.32 lakhs Saving scheme-1.5 lakhs at 7% Fixed`deposit-1.5 lakhs at 5% insurance inv. 1 lakh at 4 % for 8 years Total 2 Education 2016 ------17.04 lakhs stocks-1.5 lakhs at 15% 3 Retirement 2025----- 1.6 crores monthly savings Rs. 15000 in PF at 8% monthly savings 5000 in deposits at 5% Total 4 Housing 2025------97 lakhs provident fund 12.5 lakhs at 8 % 5 Protection----- 50 lakhs presently minimal cover 2.6 2.2 1.4 6.2 lakhs lakhs lakhs lakhs
6.98 lakhs 88.4 lakhs 23.1 lakhs 1.11 crores 58.2 lakhs
FINANCE DOCTOR
Things can be different
n
Higher returns are possible at minimal risk and make significant difference
FINANCE DOCTOR
Power of Compounding
n
For example, if 12 lakhs is required for children s education in 10 years:
Rate of Return 6% 15% 18% Monthly saving Rs. 7322 Rs. 4367 Rs. 3622
FINANCE DOCTOR
Power of Compounding
Time / Annualized returns 15 years 20 years 8% 15%
29 lakhs 49 lakhs
56 lakhs 1.25 crores
FINANCE DOCTOR
Inter Relationships
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Pension Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
TOTAL EXPENSES
TOTAL LIABILITIES
FINANCE DOCTOR
Asset QuadrantAllocation is the key decision
Maximizing wealth within business cycle & personal cycle constraints
FINANCE DOCTOR
Personal Cycle
Accumulation stage Transition stage Reaping stage
n n n
FINANCE DOCTOR
Personal Constraints
Liquidity Safety Current income
n n n
FINANCE DOCTOR
Assets –Most powerful
ASSETS Liquidity Safety 12 mths basic expense short term deposits liquid funds current income bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery
Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS
FINANCE DOCTOR
Business Cycle
Consists of economic expansions followed by contractions and revivals which merge into the expansion stage of the next cycle
FINANCE DOCTOR
Business Cycle Stage & Asset Allocation
n
n
n
Stocks will be the best assets in certain phases of business cycle Bonds will be the best assets in certain other phases Commodities might thrive in certain other conditions
FINANCE DOCTOR
Asset classes
n n n n n
Equity / Stocks Debt Insurance Derivatives Real estate
FINANCE DOCTOR
What is stock?
Two major types of financing n Debt – Borrowing & lending n Stocks – Ownership
FINANCE DOCTOR
STOCKS
Asset class with best returns and low risk – therefore most important for Wealth Creation
FINANCE DOCTOR
Total Nominal Return Indexes, 1801 – 2001
Stocks $8,800,000
Bonds $13,975
Gold
1801
FINANC 2001 E DOCTOR
$14.38
Comparative Indian Returns (As of 30-06-2005)
CATEGORY
COMPOUNDED ANNUALISED RETURN 1 YEAR 2 YEAR 3 YEAR 5YEAR
Stock Fund Debt Fund Fixed Deposits
74.83 4.42 5.0
72.83 4.58 5.0
61.64 7.87 6.0
40.57
6.0
FINANCE DOCTOR
Low Risk
Price
Time
FINANCE DOCTOR
International Experience for Stocks
n n n
USA Germany Japan
FINANCE DOCTOR
What explains the consistency of worldwide stock returns?
n n
Related to economic activity Corporate sector is the engine of economic growth
FINANCE DOCTOR
Risk Profiling
n
Can lead to erroneous allocation, to be used carefully
FINANCE DOCTOR
Market Timing
Should we be always invested in stocks?
FINANCE DOCTOR
Yes, except when stocks are severely over valued and when personal constraints are present
FINANCE DOCTOR
Bluechip fund
Worst possible time to invest in stocks
n n n
22nd February, 2000 – NAV 30.78 17th September, 2001 – NAV 15.02 10th June, 2005 – NAV 64.23
FINANCE DOCTOR
Returns
n n
Dividends Capital gains
FINANCE DOCTOR
Risks
n n n
Company specific Sector specific Market level risk
FINANCE DOCTOR
Valuation
n n n n
P/E P/B Dividend Yield Market Value/GDP
FINANCE DOCTOR
Valuation Example
Date Sensex LevelPrice/Earnings rice/Book Dividend Yield Verdict P Subsequent Move Historical range 11-29 1.9-4.1 0.95-2.4 Feb 2000 6200 28 3.98 1 overvalued Big downward move for 3 years Dec 2002 3400 14.37 2.24 2.18 undervalued 125 % returns in year 2003 August 2004 5200 15.38 2.88 2.24 undervalued move up significantly Expected to
FINANCE DOCTOR
Indian Equity Markets Strong long term potential
FINANCE DOCTOR
Advantage Asia
Mixed economic data out of US, Europe and Japan. Concerns remain on structural imbalances, especially in a high oil price and inflation scenario US is unlikely to be the world s sole growth engine, given the gaping current account deficit and low savings rates. Multiple growth engines are likely to emerge with the Asian region in particular leading the way Changing demographical profile favors developing countries as developed countries are saddled with an ageing population
Asia remains relatively insulated in an uncertain environment
FINANCE DOCTOR
Global Scenario- Growth in Brics
Goldman Sachs: Over the next 50 years, Brazil, Russia, India and China (BRICs) could together be larger than the G6 countries by 2039. UBS : By 2030, the combined purchasing power of China's and India's consumers will be five times greater than that of today's United States Growth economies driven by domestic demand offer superior investment opportunities and have a better chance of attracting new capital Global companies across sectors are looking to cut costs and improve efficiencies by outsourcing
China and India offer an unique advantage of low cost outsourcing and a vast domestic market in a world of scarce growth FINANCE DOCTOR
2010 - 2030 : Favourable Demographic Bulge
India Demographic Profile (2020)
80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -60 60 -40 40 -20 20 0 20 40 60
China Demographic Profile (2020)
Age group 80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -60 60 -40 40 40 -20 20 0 20 40 60
France Demographic Profile (2025)
80+ 75-79 70-74 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 15-19 10-14 5-9 0-4 -3 3 -2 2 1 -1 0 1 2 3
Mn people
Mn people
Mn people
20 - 35 age group : 325 mn people ( ~ 25 %)
20 - 35 age group : 308 mn people ( ~ 21 %)
20 - 35 age group : 11 mn people ( ~ 17 %)
Source: CII Conference 2002; CSFB Report; UN Population Division; BCG Analysis
Female Male
Demand growth in consumer items over the next few years to remain strong
FINANCE DOCTOR
The growth surge
70 C onsumer loans to GDP 62 60 62
Economic reform has raised product affordability through price stability Job creation in services driving creation of +200m urban consumer base by FY07 Consumer credit is just starting to reach out to next tier of towns Rising consumer aspirations reflected in high growth of cars, mobile subs Increased consumption of services such as healthcare and tourism are also spin off benefits
53 50
52 49
40
30
20 15 10 8
7
6
0 Taiwan Malaysia Thailand Singapore Indonesia Korea India Phil. HK
Source: CLSA
FINANCE DOCTOR
Services
IT exports contributes to 3.5% of India s GDP and contributes to nearly 1% of the economy s growth Nearly 500,000 employees directly recruited by IT exports growing at a fast pace of over 30% ITES is emerging to be a larger employment generator than IT Services IT explosion creating traction in real estate of over 1 million square feet per quarter in main cities. Support facilities is an additional employment generator.
India s strength
14 Indian IT Software & Services Exports (US$bn) 12.2 12 10 9.9
8
7.6
6.2 6
4 2.6 2 1.8
4.0
0 FY98 FY99 FY00 FY01 FY02 FY03 FY04
IT exports continues to push Indian economy into a higher growth orbit
FINANCE DOCTOR
Indian equities offer sustainable growth paradigm
India An economic superpower in the making as demographics and consumerism play out Corporate India Gaining in strength and confidence after a period of restructuring
Indian Markets Closed 2004 a volatile year on a high note as FII inflows turned robust, reflecting the vote of confidence amongst global fund managers for India
FINANCE DOCTOR
24 22 20 18 16 14 12 10
(%)
Industry leaders are now value creators
Return on equity Value created
Current c ost of Equity Cost of Equity
8 FY97
Source: CLSA
FY98
FY99
FY00
FY01
FY02
FY03
FY04
05CL
06CL
Capex phase in the late nineties sets foundation for value creation
FINANCE DOCTOR
Favourable indicators for investment cycle
4500 Outstanding mfg. investments (Rsbn)
Up tick in investment proposals, after 6 years of decline Capex fuelled by need for new capacity with utilization c. 90%
4000
3500
Cost competitiveness, strong balance sheets support growth with value creation
3000
Upside from step-up in spend on infrastructure led by power Concurrent investment, consumption cycle potential for +10% IIP growth
Capacity Utilisation (%) FY02 Refining Cement Steel 96 84 82 FY03 96 86 88 95 FY04 98 81 82 94 FY05E 92 82 88 90
2500
2000 94 95 96 97 98 99 00 01 02 03 04
Source: CLSA, CMIE
Aluminium Cris Infac Source: 88
FINANCE DOCTOR
25
(%)
Domestic equity ownership on the way up?
Equity savings as % of Financial Savings
20
15
10
5 Equity savings as % of Market C ap 0 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Source: RBI, CLSA
Household savings into equities bottoming out
FINANCE DOCTOR
Tax changes support rise in equity ownership
120 Distribution of financial savings by households (%)
Capital gains tax on listed equities cut; NIL for holdings > 12mths
100
80
10% (from 30%) for holding <12mths Dividends tax free since FY03
60
Friendly tax regime will remove a hurdle for 40 entry of many foreign funds Retail investors invest sub 1.5% of financial savings in equities Reduced yields on bank deposits (43% of savings), bonds also favor equities
20
0 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04
Currency Claims on Govt Providend and pension funds
Deposits Insurance funds Shares and debentures N FINA
CE DOCTOR
India
The bottom line
Economic future is bright
Per capita income expected to double by 2010 companies across sectors
will have cascading effect on
India could emerge as the third largest economy in world by 2050 India and China together expected to become a market 5 times the size of today s United States in purchasing power terms in 25 years
Medium to long term story strong
Paradigm shift in exports Robust domestic demand Improved efficiencies leading to higher wealth creation by Corporate India Under ownership of equity assets will lead to higher allocation in future as risk FINANCE perceptions change DOCTOR
How to invest in stocks?
n n n n n
Current valuation Comparative yields Time horizon Diversification When to take profits?
FINANCE DOCTOR
Mutual fund Vs Direct equity
n n
n
Debate redundant Personal choice of control vs convenience Basic principles of diversification and time horizon should be followed
FINANCE DOCTOR
What is a mutual fund?
n
Collection of money from a large group of investors, pooling it and investing in various securities, in line with the fund’s specified objective
FINANCE DOCTOR
Equity Fund Style
Growth
Blend
Value Large Mid Small
FINANCE DOCTOR
Types of Mutual Funds
n n n n
Diversified equity Index Tax planning Sectoral
FINANCE DOCTOR
RANKINGS
Forward looking as compared to traditional rankings based only on past performance Criteria n Past performance n Resilience in the falling market n Risk n Stability of fund management n Investment style n Costs n Service levels FINANCE n MNC s Indian orientation
DOCTOR
EQUITY DIVERSIFIED PERFORMANCE
NAME 3 MONTH RETURN (As of 30-06-2005) 1 YEAR 2 YEAR 3 YEAR 5YEAR
Index HDFC Equity Franklin India Blue Chip Magnum Contra Franklin Prima
9.09 10.37 7.04 10.51 8.15
47.49 61.68 42.86 98.87 74.83
39.93 56.91 53.72 88.77 72.83
28.04 49.61 45.20 59.08 61.64
8.58 27.63 22.22 38.88 40.57
FINANCE DOCTOR
Active Vs Passive
Active funds have outperformed passive funds by significant margin
FINANCE DOCTOR
Bluechip Composition
Franklin India Bluechip fund jan 31, 2005 no. name 1 Grasim 2 Infosys 3 SBI 4 ITC 5 HPCL 6 Hindalco 7 Reliance 8 BPCL 9 Satyam 10 TISCO Weighted P/E % 6.5 6.19 5.9 5.5 5.4 5.3 5.2 4.6 4.5 4.2 P/E 13 36 9.3 19 9 14 12.3 12 19.5 7.6 15.5 FINANCE
DOCTOR
Prima Composition
Franklin Prima jan 31,2005 no. name 1 Indian rayon 2 LIC housing fin. 3 IPCA labs 4 eicher motors 5 MICO 6 goodlass nerolac 7 amtek auto 8 birla corp. 9 GE shipping 10 raymond % 7.5 6.5 5.5 4.4 3.9 3.8 3.4 3.2 3.1 2.9 P/E 26 13.3 11.2 17 17.4 14 25 18.5 4.6 10 16.4 FINANCE
DOCTOR
Weighted P/E
INVESTMENT TAXATION
Equity / Equity Funds n Long term capital gains tax = 0 n Short term capital gains tax = 10% n Dividends exempt from dividend distribution tax Dividend reinvestment, FIFO n Section 80C, ELSS, SIP
FINANCE DOCTOR
Allocation for Stocks
10 lakhs to be invested: Franklin Bluechip 2 lakhs Fidelity Fund 2 lakhs HDFC Equity 3 lakhs Franklin Prima 4 lakhs
FINANCE DOCTOR
Conclusion
n
n
Stocks are the best assets for wealth creation However these have to be utilized in a certain manner
FINANCE DOCTOR
Debt
FINANCE DOCTOR
Debt
Two major sources of financing n Stocks – Ownership n Debt – Borrowing and lending
FINANCE DOCTOR
Fixed Income Securities
n
n
Debt also known as fixed income Bond is the most familiar debt security
FINANCE DOCTOR
Bond
n
A long agreement between borrower & lender stating the terms of a loan
n n n n
Principal Interest Maturity Face value
FINANCE DOCTOR
Characteristics
Steady instruments n Moderate returns n Providing stability under difficult conditions Bonds are wealth preservers while stocks are wealth builders
n
FINANCE DOCTOR
Unique proposition
Low or inverse correlation with stocks Generally useful in business cycle stage where stocks are not favored Today’s example
FINANCE DOCTOR
n
n
n
Types of bonds
Two most useful factors for categorization n Issuers and their credit worthiness n Maturity
FINANCE DOCTOR
Types of bonds
n n
Government bonds Corporate bonds
FINANCE DOCTOR
Yield to maturity
Yield on a bond, taking into consideration the price paid, interest to be received and the principal amount to be repaid at maturity
FINANCE DOCTOR
Price Yield Relationship
Inversely Related
FINANCE DOCTOR
Return
n n
Coupon payment Capital gain
FINANCE DOCTOR
Risk
Can fixed income securities be considered risk less?
FINANCE DOCTOR
Risk
n n n n
Credit Risk Interest Rate Risk Reinvestment Risk Liquidity Risk
FINANCE DOCTOR
What should be counted as Debt in portfolio?
n n n n n
Debt Funds Bonds bought directly Bank deposits Small saving schemes Provident funds
FINANCE DOCTOR
Debt & Personal Cycle
Useful for every category within asset quadrant
FINANCE DOCTOR
Debt Fund Style
Credit Quality
Interest rate sensitivity
High
Medium
Low High Medium Low
FINANCE DOCTOR
Types of debt funds
n
n n
n n n n
Gilt funds duration > 3 years, sovereign credit Gilt short term duration 1 3 years Debt medium term duration 3 6 years, both corporate & Govt. Debt short term Debt ultra short term (liquid funds) Floating rate fund Hybrid funds
FINANCE DOCTOR
DEBT FUNDS PERFORMANCE
(As of 30-06-2005)
NAME ANNUALISED RETURN (EXCEPT FOR 3 MONTHS) 3 MONTH 1 YEAR 2 YEAR 3 YEAR
HDFC Gilt Kotak Bond Prudential ICICI short term DSPML floating rate Can liquid Templeton MIP
0.23 1.53 1.74 1.32 0.10 (7days) 2.37
-0.40 4.42 5.20 5.02 0.20 (14d) 9.94
2.30 4.58
8.27 7.87
0.41 (28d) 10.56 10.83
FINANCE DOCTOR
INVESTMENT TAXATION
Debt Funds n Long term capital gains tax = 10% n Short term capital gains tax = treated as normal income n Dividends tax free in hands of investors, 12.5% dividend distribution tax
FINANCE DOCTOR
Insurance
FINANCE DOCTOR
Insurance
n
n
n
Financial protection against unexpected event A risk management tool, a risk transferring product Similar to option
FINANCE DOCTOR
Low insurance penetration in India
Total insurance premium as a % of GDP is very low comparatively
FINANCE DOCTOR
Protection & Investment
n
n
Insurance generally sold as a mixed productprotection+investment Main issue- how good is the comparative performance of insurance investment ?
FINANCE DOCTOR
Premium
n
Dependent on probability distributions and individual factors (actuarial studies)
FINANCE DOCTOR
Types of Policies
n n n n n n n n
Term insurance Endowment Money back Whole life Pension policies Unit linked Children s plans Riders
FINANCE DOCTOR
Term insurance=pure protection All other policies=term insurance+investment
FINANCE DOCTOR
Calculation of ‘Rate of Return’ on ‘Insurance Investment”
n
n
n
Reduce everything to actual cash flows Deduct term premium from actual premium paid Calculate rate of return
FINANCE DOCTOR
With Profit Endowment
n n n n n n
Annual premium=Rs. 22,617 Payment period=20 years Expected payback=Rs. 9.4 lakhs Term premium=Rs. 1500 PMT= Rs. 21,117 Rate=7.75%
FINANCE DOCTOR
Money Back
n n n
n n n
Annual premium=Rs. 34,123 Payment period=20 years Expected payback=Rs. 1 lakh at 5,10,15 years and 6.4 lakhs at 20 years Term premium=Rs. 1500 PMT= Rs. 32,623 Rate=5.15%
FINANCE DOCTOR
Calculation of Rate
m oney bac k year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 c a s h fl o ws -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 65877 -34123 -34123 -34123 -34123 605877
IRR calculation 5.15%
FINANCE DOCTOR
Whole Life
n n n
n n n
Annual premium=Rs. 11,855 Payment period=35 years Expected payback=Rs. 8 lakhs at the age of 80 years Term premium=Rs. 1500 PMT= Rs. 10,355 Rate=less than 3 %
FINANCE DOCTOR
Unit linked Insurance Plans (ULIPs)
n
n
Returns are much less than comparable investment products Additionally, entry costs are very high
FINANCE DOCTOR
Pension Plans
n n n
Accumulation phase Vesting Generation of annuity returns
FINANCE DOCTOR
Taxation
n n n
Payment-exempt Accumulation-exempt Maturity-exempt
FINANCE DOCTOR
Taxation of ELSS
n n n
Payment-exempt Accumulation-exempt Maturity-exempt
FINANCE DOCTOR
Overall Comparison
n n n n n
Return-inferior Risk-same Costs-higher Taxation-same Liquidity-inferior
FINANCE DOCTOR
Conclusion
n
n
n
Insurance is tremendously beneficial product for protection But investment performance and costs are inferior to those of mutual fund Conclusion only term insurance policy should be bought till the investment performance comes up
FINANCE DOCTOR
Estimating Appropriate Cover
n
n
n
Present income approach- a lump sum which can generate a return almost equivalent to the present income. Roughly 10 times the annual income is a good estimate In the case study, 50 lakhs will be the amount
FINANCE DOCTOR
Derivatives & Structured Products
FINANCE DOCTOR
Derivatives
n
n
A derivative security derives its value from an underlying Underlying can be stocks, commodities, bullion, currency & many others
FINANCE DOCTOR
Basic Types
n n
Futures Options
FINANCE DOCTOR
Rationale
n
n
n
Actual transaction not happening today Instead, there is an intent or commitment Origin lies in both buyers and sellers benefiting
FINANCE DOCTOR
Oil Prices
An example of usefulness of derivatives
FINANCE DOCTOR
Futures
n
n
Obligation to buy or sell an asset at a pre-specified price and at a pre-specified time Quantity is also determined before hand Note that this is an obligation
FINANCE DOCTOR
Terms
n n n n
Expiration date Initial margin MTM margin Cash settled vs delivery settled
FINANCE DOCTOR
Options
n
Options are deferred delivery contracts that give the buyers the right, but not the obligation, to buy or sell an asset at a prespecified price and on or before a specified date Note that this is a right
FINANCE DOCTOR
Option Terminology
n
Call Option
n
Right to buy Right to sell has the right but not the obligation has the obligation but not the right
FINANCE DOCTOR
n
Put Option
n
n
Option Buyer
n
n
Option Writer/Seller
n
Option Terminology
n
Option Premium
n
Price paid by the buyer to acquire the right Price at which the underlying may be purchased or sold Last date for exercising the option Date on which the option is actually exercised
n
Strike Price OR Exercise Price
n
n
Expiration Date
n
n
Exercise Date
n
FINANCE DOCTOR
Derivatives in Investment Management
n n n
Hedging Portfolio rebalancing Capital protection
FINANCE DOCTOR
Taxation
n
n
For an investor short term & long term capital gains taxation For a business loss can be set off against other business income
FINANCE DOCTOR
Real Estate
FINANCE DOCTOR
Real Estate Characteristics
n n n
n
n
n
Dominant role in total wealth Housing one of the biggest expenses For most people, biggest & one of the best investment decisions Decision making not based on financial aspect alone Need for shelter & prestige also gets fulfilled Bungalow occupies an important place in an individual s psyche Deewar s FINANCE Maa comparison
DOCTOR
Real Estate Characteristics
n n n n
n
n n
Fall back asset in unfavourable times like in rampant inflation Important role in multi asset portfolio Low correlation with bonds and stocks Versatile and multifaceted liquidity, safety & yield enhancing Holding a physically visible asset is good Financial leverage Taxation benefits FINANCE
DOCTOR
Historical Return/ Risk
Investment statistics from Real Estate and other categories of Assets 1973-1984 (USA statistics-but provide an indication about comparative return & risk) Investment Average rate of return Risk-Std. Deviation Residential Real estate 10.53% 4.44% Farmland 14.03 11.06 Business real estate 10.78 2.77 Common stocks 9.62 19.71 Corporate bonds 7.51 13.92 Small stocks 21.96 28.11
FINANCE DOCTOR
Risks
n n
n n n
Market Risk Property destruction & cost of replacement Developer Risk, Title deeds Tenants refusing to vacate Structural flaws
FINANCE DOCTOR
Risks
n n n n n
Changes in neighborhood quality Liquidity risk High transaction costs Loan rate risk Landlord s duties onerous
FINANCE DOCTOR
Distinctiveness of Real Estate
n n
n n
n n
Psychological value Concentration rather than diversification Each unit is distinct Liquidity less, transaction cost much higher Ideal time horizon longer than stocks There is no exchange for uniform price discovery
FINANCE DOCTOR
Placing Real Estate in Portfolio
NEEDS LIQUIDITY PORTFOLIO INSTRUMENTS PERCENTAGE RETURN
SAFETY
Real Estate for self-occupation
YIELD ENHANCING Real estate as an investment
FINANCE DOCTOR
Valuation of Real Estate
n
Physical
n n n
Market sentiment n Demand & Supply When demand goes up supply might follow at a sluggish pace
n
n n n
Land Labor Material
Zoning/ Planning Laws Controlled Release of Land Stock Limited supply of suitable land in a city, FINANCE area or a compound
DOCTOR
Valuation of Real Estate
n
n n
Like for any other asset, valuation determined by income stream its ability to generate rent is an important determinant Rental yield R/P Potential for capital gain
FINANCE DOCTOR
Financial Leverage Factor
n
Buying cash outflows
n n n n n n
n n n
Net Buying Outflow E Net Rental Outflow R R/E Ratio also very useful for valuation
FINANCE DOCTOR
EMI as determined by house prices & interest rates Real Estate Taxes Utility Payments Home Insurance Repairs & Upkeep Savings by Tax Reduction
Real Estate Cycle
n
n
Superimposed on the main business cycle are demand supply curves of a city, sub-area and even going down to the unit itself While Real Estate in general might be depressed, one house might be fetching a very good price
FINANCE DOCTOR
Gurgaon Example – Story of a Township
First Phase 1988 to 1992
n n
n n
South of South Delhi Billed as IT Park, residential, commercial & self sufficient township Attractive prices Early adopters, investors & NRIs
FINANCE DOCTOR
Gurgaon Example – Story of a Township
Second Phase 1992 to 1996
n n n n
n n
Slow release of land stock Hype about investment potential Post reforms 1992 economy Powerful real estate cycle started kicking in Low occupancy, rents remained low R/P ratio very low
FINANCE DOCTOR
Gurgaon Example – Story of a Township
Third Phase 1996 to 2003
n
n
n
n n n
Investors taking profits by selling houses Developers increased the supply, looking at high prices Slow implementation of economic reforms People (end users) started moving in House prices crashed, rents went up FINANCE R/P ratio high
DOCTOR
Gurgaon Example – Story of a Township
Fourth Phase 2003 to to-date
Economy growing at a healthy rate n Township living up to its initial potential n Multiplexes, malls, smart residential units, multinational companies, schools & hospitals coming up n Lower interest rates & booming housing loans n 8 lane highway from airport coming up Prices surging, moved by 250% in someA N C E FIN areas in 2004. DOCTOR
n
Understanding Real Estate Cycle & Valuation is Beneficial
n
n
In Gurgaon the cycle was giving strong signals in 2003 that the property was severely under valued Surprisingly the market stayed low for quiet some time, thus the opportunity was there for taking
FINANCE DOCTOR
Understanding Real Estate Cycle & Valuation is Beneficial
Other important factors are: n Motivated seller n Importance of negotiation n R/P & R/E ratios time series and comparative n Bid offer spreads very high to get information as buyer and seller n No price discovery mechanism n Multiple demand supply curves
FINANCE DOCTOR
Beneficial Role of Real Estate in Portfolio
n
n
n
Presently real estate positively correlated to stocks and negatively to bonds Flight to safety correlation with other asset classes can break easily Analytical studies show that addition of real estate to portfolio is very beneficial returns increase while risks go down
FINANCE DOCTOR
Buying Vs Renting
n n
Buying for own usage Buying for investment
FINANCE DOCTOR
Buying for own usage
n n
n n
Forced saving Yields as compared to other safety instruments is much higher Reduces the portfolio risk Tremendous financial benefit with taxation and leverage
FINANCE DOCTOR
Buying for own usage
n
Simulation example
n
n
n
Buying entailed cash outflow of Rs. 9,450 There was an inflow in terms of HRA & Taxation benefit of Rs. 4,450 With the present value of 20 lakhs & a monthly outflow of Rs. 5,000 the effective interest on home loan is less than 2%
FINANCE DOCTOR
Buying for Investment
n n n n n n
Concentration Illiquid High transaction cost Disputed titles Weak tenancy agreements Returns can be higher in other asset classes
FINANCE DOCTOR
General Principles
n n n
n
n n
Long horizon Valuation R/P & R/E Intensive macro & localized research Comparison with other asset classes Developer s track record Legal details to be sorted out
FINANCE DOCTOR
Taxation
n n
n
n
Interest on home loan up to Rs. 1,50,000 tax deductible Payment of Rs. 1,00,000 for returning home loan principal is also tax deductible Long term capital gain (> 3 yrs) taxed at 20% with inflation indexation This can be saved if gain invested in property or specified bonds
FINANCE DOCTOR
Fixed Vs Floating
n n
n
n
Precise placing of interest rate cycle is difficult Estimate broadly whether we are at the bottom, middle or at the top of the cycle Presently we have just started moving up from lowest point of the cycle Locking in a fixed rate might be beneficial for a long term loan
FINANCE DOCTOR
Fixed Vs Floating
n n n
n
9.25% floating rate-- Rs. 916 EMI per lakh for 20 years 9.75% fixed rate -- Rs. 949 EMI per lakh for 20 years Even if the floating interest rate goes up to only 9.75% in next two years, EMI will go up to Rs. 944, because the loan amount has gone down only to Rs. 96,000 Overall in 20 years in floating, the borrower might end up paying a lot more FINANCE
DOCTOR
Conclusion
n n
n n
n
Versatile & favoured asset class For own usage, owning it under more circumstances is the correct decision Effective long term investment Increases the return while reducing the risk of the portfolio Does well under unfavourable circumstances
FINANCE DOCTOR
Conclusion
n n n n n
However, when bought for enhancing yield, investor should be very careful Return could be less than other assets Illiquid with high transaction costs Concentrated Local factors need intensive research this prevents glaring mistakes while facilitating tremendous investment opportunities
FINANCE DOCTOR
Behavioural Finance
FINANCE DOCTOR
Rationality and Emotion
n
n
Every investment involves a financial commitment and an emotional commitment Rational advice, even if supported by lots of data, is much easier to take in theory than to put in practice
FINANCE DOCTOR
Behavioural Finance
Psychological Factors can thwart rational analysis and prevent investors from achieving the best results for their portfolios n Volatility of markets cannot be explained by earnings & growth Field of Behavioural Finance
n
FINANCE DOCTOR
Nobel Prize for Behavioural Finance
n
Daniel Kahneman
n
n
Prospect theory, how individuals actually behave and make decisions when faced with uncertainty Replacing theories that assumed investors maximized their expected utility or well-being and always acted rationally
FINANCE DOCTOR
Mismatch between great opportunities & actual results
Date Dec. 93 Apr. 95 Feb. 97 Feb. 00 Sep. 01 Dec. 02 Dec. 03 Apr 23. 04 May 17. 04 Oct 4. 04 NAV Market View
4.69 Introduction of Fund 10.10 Reforms progressing well 5.00 Slow implementation of reforms 30.78 Indian technology, internet, new millennium 15.02 Global melt down 23.31 Early signs of Indian corporate resurgence 51.42 Second stage of reforms, good earnings growth 56.75 India shining, NDA expected to win 43.51 Surprising election results, Sonia as PM 54.98 Reforms seen as irreversible
FINANCE DOCTOR
Investor Psychology
Date Dec. 93 Apr. 95 Feb. 97 Feb. 00 Sep. 01 Dec. 02 Dec. 03 Apr 23. 04 May 17. 04 Oct 4. 04 N A V Investor Psychology 4.69 Memories of gold going out, 1992 scam 10.10 Investor confident and gets in 5.00 Investor sells at a loss, vows never to invest 30.78 Draws up courage to get in at 25 15.02 Extremely disillusioned, sells at a loss 23.31 Remembers the past unfavorable experience 51.42 Gets in at 42 56.75 Period of happiness, expecting more gains 43.51 Unnerved by rapid erosion 54.98 Can t really understand, state of confusion
FINANCE DOCTOR
The Emotions of Investing
FINANCE DOCTOR
Follow the Crowd & Asset Bubbles
Herding instinct n Disbelief that a large group of people could be wrong n Hard to remain separate from a crowd n Social dynamics & facts n Information cascade Asset bubbles, prices overshooting what is determined by fundamentals
n
FINANCE DOCTOR
Self Attribution Bias
Taking credit for a favourable turn of events, when credit is not due n Over confidence An investor or a fund manager taking credit for high returns in the year 1999 & remaining over invested in technology stocks
n
FINANCE DOCTOR
Representative Bias
n
Too many parallels between events that seem the same but are remarkably different
n
Example: Sensex at 6000 in year 2000 & at 6000 in year 2005
FINANCE DOCTOR
Reluctance to accept randomness
n
Psychological need to know why something happens and forming a template for future events
FINANCE DOCTOR
Cognitive Dissonance
n
n
Predisposition to disregard news that does not correspond to your view Shutting out bad news
FINANCE DOCTOR
Reference Point for Judging Performance
n
n
n
Mental accounting with purchase price as the reference point Loss aversion, much more upset about losing from this reference point Holding on to losses
FINANCE DOCTOR
Anchoring
Prospect theory predicts that investors rather than realize loss, will increase their position, since stock is now cheaper than their reference point n Anchoring in their mind more important than future prospects n Investors sell their stocks much more frequently for a gain rather than a loss They run their losses and take early profits rather than the other way round
n
FINANCE DOCTOR
Myopic Loss Aversion & Portfolio Monitoring
n
n
Tendency to base decisions on the short term fluctuations in the market Frequent portfolio changes
FINANCE DOCTOR
Applications
n n
n
n
Basic factors generating returns change far less than we think Asset allocation should be based on broad factors Investment discipline adhering to asset allocation based on long term factors Getting rid of temptation to trade stocks & other volatile assets in the short term
FINANCE DOCTOR
Applications
n n
n
n
n
Diversified portfolio Looking at future prospects rather than reference point/ anchoring Avoiding averaging if future prospects are dim Non-participation in asset bubbles (by curbing herding instinct) To buy in undervalued markets even if everybody else is selling
FINANCE DOCTOR
Putting it all together
FINANCE DOCTOR
SCORE CARD
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution Monthly in Rs. ASSETS Liquidity 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate for own usage fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS LIABILITIES Short term credit card loan borrowings on life insurance personal loan installment accrued income taxes other obligations Long term home loan principal yet to be repayed loans to purchase investmnt assets loans to purchase personal assets amount present return 50000 3% 0 0 150000 0 1250000 0 0 150000 300000 150000 0 0 0 0 0 0 100000 2150000
As Is
7%
8%
55000 15000
5% 3% 15%
6%
4%
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary any other
40000 7000 4000 3000 8000 2000 3000 3000 5000 0
0 0 0 0 0 0 0 0
TOTAL EXPENSES
35000
TOTAL LIABILITIES
FINANCE 0 DOCTOR
If ‘As Is’ continues
1 Education 2013 -----14.32 lakhs Saving scheme-1.5 lakhs at 7% Fixed`deposit-1.5 lakhs at 5% insurance inv. 1 lakh at 4 % for 8 years Total 2 Education 2016 ------17.04 lakhs stocks-1.5 lakhs at 15% 3 Retirement 2025----- 1.6 crores monthly savings Rs. 15000 in PF at 8% monthly savings 5000 in deposits at 5% Total 4 Housing 2025------97 lakhs provident fund 12.5 lakhs at 8 % 5 Protection----- 50 lakhs presently minimal cover 2.6 2.2 1.4 6.2 lakhs lakhs lakhs lakhs
6.98 lakhs 88.4 lakhs 23.1 lakhs 1.11 crores 58.2 lakhs
FINANCE DOCTOR
Should Be
INCOME Active sources employment salary professional income business income Passive sources rent from property investment income royalties any other Deductions Taxation COMBINED INCOME post taxn. Provident Fund Contribution HRA & Taxation Benefit Monthly in Rs. 6months basic expense amount present return short term deposits liquid funds 200000 3% Safety current income generating bonds 0 saving schemes 0 real estate on rent 0 long term provident fund,pension plans 220000 8% rbi bonds 0 real estate own usage(housing) 2500000 fixed term deposits 0 5% gold, jewellery 300000 3% Yield Enhancing stocks-direct equity 30000 15% stocks-mutual funds(Education) 900000 15% bonds 0 bond funds 0 6% real estate for investment 0 commodities 0 art,antique 0 investible part of insurance policy 0 4% TOTAL ASSETS 4150000 LIABILITIES Short term credit card loan 0 borrowings on life insurance 0 personal loan installment 0 accrued income taxes 0 other obligations 0 Long term home loan principal yet to be repayed 2000000 loans to purchase investmnt assets 0 loans to purchase personal assets 0 ASSETS Liquidity
55000 3000 4450
NET INCOME EXPENSES Food Clothing Housing Children related Health & Insurance Transportation Appliances Discretionary Housing Loan EMI Term Ins. premium(protection)
56500 7000 4000 3000 8000 2000 3000 3000 5000 9450 2000
TOTAL EXPENSES
46500
TOTAL LIABILITIES
2000000
FINANCE DOCTOR
‘Should Be’ Adjustments
n n
n
n
n
n
n
Home for own usage bought with 5 lakhs down payment, 10 lakhs soft loan from the company and 10 lakhs as home loan from the bank Term insurance of 50 lakhs cover bought with a premium of Rs. 2000 per month Monthly savings of Rs. 13,000 now being channelized into stock funds except for the mandatory requirement for Provident Fund, both for Retirement Investible money earmarked for children s education moved to stock mutual funds Minimal money in Existing Provident Fund Account, in keeping with whatever is required by rules Liquidity component now has amount equivalent to 6 months expenses FINAN Gold & Jewellery totally as before for marital insurance C E
DOCTOR
If ‘Should Be’ Implemented
EDUCATION 1 Education 2013 -----14.32 lakhs 5 lakhs at 15% for 8 years 2 Education 2016 ------17.04 lakhs 4 lakhs at 15% for 11 years RETIREMENT 2025- 1.6 crores Rs. 10,000 every month at 15 % for 20 years Rs. 3000 every month at 8% for 20 years HOUSING 2025-----97 lakhs House worth 25 lakhs bought today 5 lakhs down payment Soft loan of 10 lakhs to be returned after 20 years, present lump sum in PF earmarked . Net outflow of Rs. 5000 every month PROTECTION insurance premium,monthly outflow of Rs. 2000 15.3 lakhs 18.60 lakhs 1.5 crores 17.6 lakhs
FINANCE DOCTOR
‘Should Be’ Asset Allocation
ASSETS Liquidity 6months basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund,pension plans rbi bonds real estate own usage(housing) fixed term deposits gold, jewellery Yield Enhancing stocks-direct equity stocks-mutual funds(Education) bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS art,antique investible part of insurance policy TOTAL ASSETS amount allocation % 5% 200000 0 0 0 220000 0 2500000 0 300000 30000 900000 0 0 0 0 0 0 4150000 0 0 4150000 5% 60% 7%
22%
0%
100%
100%
FINANCE DOCTOR
After 5 Years
12 mths basic expense amount short term deposits liquid funds current income generating Safety bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
40%
30% 20%
100%F
INANCE DOCTOR
Asset Allocation 25 – 30 Years Old (Accumulator)
12 mths basic expense amount short term deposits liquid funds current income generating Safety bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
10%
75% 5%
FINANCE 100% D O C T O R
Asset Allocation 40 – 45 Years Old (Mid Life Accumulator/ Harvester)
12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
30%
50% 10%
100%F
INANCE DOCTOR
Asset Allocation 40 – 45 Years Old (Mid Life Accumulator/ Harvester)
Business Conditions Change – P/E at 24, Bond Yields at 10.5
amount 12 mths basic expense short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
35%
15% 40%
100%F
INANCE DOCTOR
Asset Allocation 55 – 60 Years Old (Harvester)
ASSETS Liquidity 12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS allocation % 10% 50%
20%
70%
10% 10%
100%F
INANCE DOCTOR
Asset Allocation Double Income High Liquidity
12 mths basic expense amount short term deposits liquid funds Safety current income generating bonds saving schemes real estate on rent long term provident fund pension plans with fixed return rbi bonds short term debt funds real estate for own usage-own equity fixed term deposits gold, jewellery TOTAL Safety Yield Enhancing stocks-direct equity stocks-mutual funds bonds bond funds real estate for investment commodities art,antique investible part of insurance policy TOTAL ASSETS ASSETS Liquidity allocation % 10%
15%
60% 15%
100%F
INANCE DOCTOR
Implementation
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Pay yourself first Automate your plan
FINANCE DOCTOR
Summary
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Everybody can be wealthy Achievable at minimal risk and with minimal adjustments Know values & specific goals Organize information & utilize score card Asset allocation is the key decision Know characteristics & general principles of various asset classes Put together a plan consistent with your objectives Automate your plan so that it gets FINANCE implemented DOCTOR
