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This old article may have references to outdated tax rules and laws. For up-to-date information on taxation of mutual funds, refer to https://www.valueresearchonline.com/tax/

Term insurance is as close to a universal financial need as can be. With the exception of those who do not have any dependents, practically every adult has family members who will face financial hardship if he or she passes away. The only suitable way to guard against this is to buy term insurance. While most of us agree with this much, we end up making mistakes while deciding how much to insure for, and how to insure.

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However, if you think logically it’s quite easy to figure out the correct answers to these questions. Here’s how to do it:

How to decide your insurance needs

Decide how much money your family will need if you die suddenly. Don’t just guess or pull a number out of thin air, actually sit and do some posthumous financial planning. A good rule of thumb is ten years’ income but there could be other factors influencing it. Some of these factors could be whether you own a house or other property; what kind of income your spouse or other family members have and how many children you have.

Let’s look at this in detail. The only reasonable way of making this decision is to unemotionally create a financial plan that your family should follow if you die suddenly. Families also have to consider the impact of both parents passing away in an accident. The impact of such a tragedy could be greater than just the sum of two deaths occurring separately. Here are some heads to consider.

Time left to retirement: Before buying any term insurance plan, an individual must assess time left to retire and a sufficient sum assured. Time remaining to retire here does not necessarily mean retirement from your job, it means the time period till your family members will depend on you for their financial needs. Once you know the number of years for which you have to stand as the financial support, look out for policies that offer the matching policy term and maturity age. For instance if you are supposed to retire after 20 years, make sure that you take a minimum policy term of 20 years. It is fundamentally important to be insured at least till you pass on the baton to another family member.

Loans and debts: As far as possible, take debtors’ insurance so that your debts can be paid off straightaway. If you have a housing loan, the lender has probably made sure that you already have such insurance for that loan. Other loans need to be considered. While you can add these to your main term insurance, taking a policy where the insurance company will directly pay off lenders has the advantage that your survivors will not be tempted to carry the loans. Do not waste money in insuring unsecured personal debt like that for credit card. The card issuer cannot make your family pay so there’s no need to cover that, unlike say, vehicle loans where you wouldn’t want the family car to be possessed by the lender.

Future Expenses

The hardest part of providing for future expenses is estimating and allowing for inflation. Take a reasonable, at least 7 per cent, inflation rate into account.

Education: Insurance companies are making some attempts at designing policies that will ensure that your children’s education is paid for. What you ideally need is a policy that is conceptually term insurance, that is, which does not have any payout if your children get educated during your lifetime.

Living Expenses: Estimate what living expenses are going to be and estimate the investment needed to yield that much return. Your term insurance should be for this amount. Make a realistic financial plan and not an idealised one. Perhaps your spouse will need to start working if she doesn’t do so now. Take into account the investment needed if she would start a small business.

When it comes to ‘how much sum assured’ it is better to avoid thumb rules, as the amount to be called an adequate sum would differ for each individual. The best person to decide on the amount will be the one to be insured. Sum assured should be purely based on current lifestyle, annual family income, annual expenses, current investments (if any) and liabilities like home loan or education loan overhead. The final value after considering these figures will be the Life value of prospective insured. Most insurance companies provide a ‘Human Life Value’ calculator on their website to ease the task of calculations. Do not forget to consider inflation as the purchasing worth of R100 today, will erode with time.

It is very important to find out an apt cover because, a higher one would make you pay for the protection that was actually not required and buying a lower sum assured may not be able to take care of financial needs of your family in adverse situation. Most insurance products come with a minimum and/ or maximum sum assured under their products. It is important to check if sum assured on offer matches your requirement.

This kind of unemotional, careful and realistic thinking is really the heart of making a sudden-death financial plan. Don’t shy away from it. The fact is that Indians have a deep-set cultural antipathy against planning for their deaths. A minuscule number of Indians make a will. Even the country’s most successful and richest entrepreneur, who organised everything else about his business so carefully (and whose death was not sudden), died without making a will and left his two sons to fight public battles for their inheritance.

Buying a term plan

Buy a low-cost term insurance for 25-50 per cent more than the above amount. To avoid putting all your eggs in one basket, split the term insurance across two companies. As time goes by, your income will increase and so will prices. Keep enhancing the insurance amount to reflect changing needs. At some point as your children start earning and become independent, the need could become static or even decline.

The best option today is to avoid agents and buy an online term insurance directly from the insurance company.

Apart from the sum assured, which you would have calculated based on the above process, there are a number of other points to keep in mind:

Tenure of policy: Since term insurance policies are for a pre-defined period, it is best to opt for the long term because it is difficult to get another policy at an advanced age. Besides, the premium on a new policy may be very high at that age. Therefore, buy a policy for as long as possible. Hopefully, by the time the term policy ends, you would have accumulated enough money for your retirement corpus to secure your dependants’ needs.

Premium: Even when the sum assured and tenure are similar, the premium charged by different insurers could be different, often by a considerable margin. So do a comparison of premiums instead of buying from the first agent that approaches you.

Besides, study the various options available in the market properly. Some insurers charge lower premium rates from non-tobacco users. Rebates for higher sum assured are also offered. Always, the lower the insured’s age at the time of starting the policy, lower is the premium.

The other aspects that you need to take into consideration while buying term insurance are:

Riders: Accidental death and disability, critical illness and waiver of premium are the three common riders that most insurers offer with their term plans. Buyers should evaluate (by looking at both the benefits and the cost) whether to avail of these covers via riders or via standalone policies. Waiver of premium is one rider that should be bought with all term policies. In case of others, you are better off buying a stand-alone policy.

Medical tests: Except when the sum assured is small, the buyer has to undergo medical tests when buying a term cover. As the age and the sum assured rise, and hence the insurer’s risks increase, the tests get more exhaustive. Usually the insurance company bears the cost of these tests. Only if you buy a policy and then cancel it during the free-look period could you be required to pay for the tests.

Internet-based plans: You can purchase term insurance from a company’s branch office, its agents, and increasingly, from its website. Almost all insurance companies nowadays offer Internet-based term plans whose premiums are much lower (than of a term cover bought via an agent or branch office). Since the cost of selling via the Internet is lower, companies pass on some of their savings to their customers.

Income-tax benefits: Term insurance offers income-tax benefits under Section 80C and 80D of the Income Tax Act, 1961. You may avail of deduction up to R1.5 lakh from your taxable income on premium paid. Additional deduction up to R15,000 is available on premium paid for (medical/illness-linked) riders. Moreover, the benefits received at death are also exempt from tax under Section 10 (10D). However, the Direct Tax Code proposes to tax the death benefit from term plans.

Post-purchase pointers

After purchasing a term policy, remember the following:

Pay your premium on time: If you miss the last date of payment, you will have to pay additional charges provided you have not crossed the grace period. If the latter date has also passed, the policy will lapse and reviving it is even more difficult.

Understand the policy: Make use of the 15-day free-look period (there is a 30-day free-look period for policies bought online) to read and fully understand the terms and conditions of the policy. This is your last chance to decide whether the policy fulfils your needs. If it doesn’t, cancel it.

Finally, if protection for your dependants is what you are looking for, buy term insurance. Only with this low-cost insurance policy will you be able to purchase adequate protection for your family

 

To understand how to build a portfolio, we need to understand what the term means and what it implies. This is necessary to understand what role a portfolio plays. A portfolio is actually a leather bag, a type of briefcase. No, seriously. The original meaning of the word is simply a bag designed to carry documents in.

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It became associated with investments because in the early twentieth century, stockbrokers would keep each client’s share certificates in a separate portfolio. From there onwards, the word gradually came to mean any kind of collection of documents. In finance, it specifically mean the investments held by an investor, generally all the investments that an investor has.

However, the word’s meaning in personal finance has evolved a great deal. At Value Research, we don’t think it makes sense to use the word to just refer to a collection of all of someone’s investments. A portfolio is a lot more than a collection. For individuals, the best way to plan their investments is to have a separate portfolio for each financial goal.

Different mixes of funds, stocks and other assets lead to different risk levels and different gain expectations. Most people find it difficult to match these to what they want. If you’re asked, ‘What is your risk level?’ you’ll probably give an answer of some sort but it will just be a gut feel thing.

However, if you think of specific financial targets and think of the money needed for them, then you will be able to answer questions about risk and returns precisely. For example, you’ll need money for your daughter’s higher education after three years. You’d like to buy a house at least ten years before retirement. You’d like to go on a vacation to Europe after two years. You’d like R2 lakh to always be available for emergencies.

Each of these goals is very precise. The risk you can take with it, as well as the amount of money needed can be quantified quite precisely. Therefore, it is relatively easy to decide what kind investments should be made for each of them. In the Value Research way of thinking, there is no concept of an individual’s portfolio. Instead each individual must have many portfolios, one for each financial goal. The other important thing is that a portfolio is not simply a collection. It has different parts that fit together in specific roles and complement each other. There could be three funds, of which one provides gains and two stability. In hindsight, it’ll later appear that you could have stuck with one or the other but both types played a role.

With experience, you’ll learn the basics of constructing a portfolio as well as learn about some model portfolios.

How to build a Portfolio
The first step towards building a portfolio is to have a clear goal. Once you have that, then it’s relatively easy to build the rest of the portfolio in a way that’s suitable for meeting your goals.

In Value Research’s way of thinking, goals that need to be fulfilled in the short-term are fundamentally different from long-term goals. Short-term goals are best fulfilled using fixed-income investments. These could be a bank or a fixed deposit or it could be a post office deposit.

If you are saving gradually towards such a goal, then the post office recurring deposit is a reasonable tool. It yields a return of 7.5 per cent per annum. However, this should only be used for savings targets that are no more than two to three years away. Any longer and the ill-effects of the low returns will start becoming more and more meaningful.

For fulfilling long-term financial goals, the best option is to use a portfolio comprising of equity mutual funds. As we have read, equity is the only type of asset that can ensure that your money grows faster than inflation and does not actually lose value in real terms. Fixed-income investing is safer, but generally cannot beat inflation.

However, equity mutual funds can be volatile and thus only suitable for long-term investments. Over the short-term, the ups and downs of the stock markets could very well lead to temporary losses. Because of this, we do not recommend investing in equity mutual funds if your financial goal is nearer that about three to five years.

This point is beautifully illustrated in the accompanying graph. This graph traces the growth of an investment over ten years in three different types of investments. We have chosen three types of funds and calculated the average performance of all funds that are more than ten years old. What looks risky in the short-term can work very well in the long-term. What looks like volatility can actually bring great returns.

Two of these funds are equity oriented. Of them, one invests in large companies while the other invests in smaller companies. The third type are very short-term fixed-income funds called liquid funds. These funds are heavily regulated to be closest to risk-free investments. For the purpose of understanding returns in this graph, they can be considered equivalent to bank and other deposits.

 

For what is supposed to be a simple (and simplifying) idea, there are way too many misconceptions about the SIP (Systematic Investment Plan) way of investing. At Value Research, we get a steady stream of investor emails asking questions that show that for some, SIPs remain misunderstood and misused. Here’s a typical one, ‘The markets are said to be in an overbought zone if Nifty valuation rises above 22. Is it wise to hold SIPs in such period?’. This is just one such example. In general, those who have a punter’s approach to investing carry over that approach to SIPs, trying to stop and start SIPs by timing the markets.

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Back in 2010, I remember investors claiming that SIPs were no good and that they had barely broken over the preceding years. Generally, these were people who had stopped their SIPs after the crash of 2008, and then restarted after the recovery in 2009.

The basic idea behind SIP is that while the general direction of an equity investment is upwards, it is not possible to reliably predict the actual fluctuations that it may undergo as part of its general trend. Instead of trying to time one’s investments, one should regularly invest a constant amount. As time goes by and the investment’s NAV or market price fluctuates, this will automatically ensure that when the price was low, you ended up purchasing a larger number of shares or units. Eventually, when you want to redeem your investment, all the units are worth the same price. However, because your SIP meant that you bought a larger number of units whenever the price was low, your returns are higher than they would have been otherwise.

That’s the way it should work. However, you have to allow it to work by going on investing when the market is low and not try to time it. At one level, SIPs are nothing more than a psychological trick to make you invest when the market is low without having to guess what it will do next.

Functionally, there is nothing common between Equity Linked Savings Schemes (ELSSs) and Unit Linked Insurance Plans (ULIPs). It’s a basic rule of saving to not mix up insurance and investments. ELSSs and ULIPs are two different products that serve different purposes. While ULIP is a mix of life insurance and investment offered by life insurance companies, ELSS is an equity fund. Both are eligible tax-saving investments but the similarity ends there.

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ELSS have predictable costs, easily understandable returns and are transparent about how the fund operates and what it invests in. Not so with ULIPs. From the premium paid, the insurer deducts charges towards life insurance (mortality charges), administration expenses and fund management fees. So only the balance amount is invested. ULIPs have high first year charges towards acquisition (including agents commissions). In order to evaluate the return generated by a ULIP and thus compare it with another investment, you need to take into consideration only that portion of the premium that is invested in a fund. However, you cannot access this information very easily.

In a ULIP, the mix of investment and insurance prevents savers from having a clear cost-vs-benefit understanding of either of the two components.

In a ULIP, your money is locked for a longer period of time. In this kind of investment you have to sacrifice on transparency and liquidity as well. In theory, ULIPs have a five year lock-in, but since terminating the policy early affects returns adversely, in effect it is a ten to fifteen years commitment. The high costs, difficulty in evaluation, lack of transparency and low liquidity doesn’t make ULIP a suitable investment vehicle.

 

Under Indian tax laws, savers have a complete range of tax saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits, National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others. Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

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One common reason is that there is a confusion of goals between saving tax and making investments. The typical investor makes this decision either in late March under the duress of having the deadline slip by, or under intense pressure by a salesman who drives home the fact that time is running out. At the end of the day, we make sub-optimal investment decisions and when we realise the fact later, we console ourselves by saying that at least we got tax benefits for the investments. This approach proves expensive in the long run.

This duality of concern-tax as well as investments-prevents clear-headed thinking about just exactly what one is getting out of an investment and whether the quantum of disadvantages are actually worth the quantum of tax benefits that are being obtained. Investors should work on eliminating both these sources of poor decision-making-time pressure as well as not thinking through about these investments. Eliminating time pressure is simple-just plan these investments as early in the year as possible and once you start in time, there’s no need to stop after a year.

For most people, the investment that should make most sense is in an ELSS. Salary-earners generally have some of the permitted amount going into fixed income through PF deductions and to balance that, equity is advisable. ELSSs are unique in being the only viable tax-saving investment within Rs 1.5 lakh limit that brings the benefits of equity returns. Sure, there are two other options that give equity-linked returns-ULIPs and the National Pension System (NPS). However, ULIPs have a longer long lock-in period of 5 years coupled with high costs and poor transparency. The NPS is a retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age. There’s no way a three year lock-in product like the ELSS can be compared to the NPS.

For many beginner investors, it makes an excellent gateway product in which they get the first taste of equity investing and of mutual funds. You end up investing in these funds because the tax-savings attracts you and it has the shortest lock-in. This experience encourages investors to invest in equity mutual funds over and above their tax-saving needs. Once you have a taste of long-term equity returns, then you end up trying other types of equity investments as well.

Equity investment carry higher risk over the short-term. However, for investment periods of three to five years or longer, the risk on equity investments is considerably lower. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation. Like all equity investments, the best way of investing in an ELSS is through monthly SIPs throughout the year. That’s also the way to avoid any last minute rush. At the beginning of every year, estimate the amount you have left over from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP.

Even for those who follow the commonsense rule of investing only gradually in equity mutual funds, investing large sums of money becomes a problem. Normally, gradual investing works out well when one is doing an SIP from a monthly income. Every month, a fixed sum flows into the investment, leading to cost averaging and eventual high returns. This pattern of investment often generates good returns quickly and investors who sticks with it for a couple of years become faithful followers of SIP investing.

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The problem arises when they come into a big sum which is outside of their regularly scheduled inflow. This could be a bonus from an employer, or an asset sales, or maybe a very lucky pre-Diwali night. For anyone who has understood the efficacy of SIP, the right way to go about this kind of an investment is to put it into a liquid fund, and then do a monthly transfer from there. This regular transfer from one fund to another is called an STP (systematic transfer plan).

Spreading the investment over the right time period is the key. The STP can be done over a time period of three to four months or across several years. Investors are frequently at a loss as to how many monthly installments to break up the investments into. Since there is no underlying inflow as in the case of a salary that feeds an SIP, this is entirely at the discretion of the investor.

The right way to decide is to stop and consider the motive behind investing a lump sum gradually, in bits and pieces instead of in one lot. Clearly, we do it so that we don’t catch a market peak. Consider the example of someone who came into R20 lakh in December 2007 and then invested it all in an equity fund. In four months, the money would be reduced to less than R10 lakh. In some cases, funds could have gone down to R5 or 6 lakh. After taking such a big hit, a person may never invest again. It will take about six years for him to break even.

However, suppose this investor had invested gradually over 12 months. In that case, only about a tenth of the money would lose a lot of its value. Overall, averaging over a year, the acquisition cost would be such that the investment would hardly ever be in a loss. Of course, I’ve taken an extreme example to illustrate the concept, one that takes the investor from an all time high peak to a low point. You could have started a little earlier, say in 2006 and then spread the investment over a longer period.

However, if you actually look back at the markets over the last decade, you will realise that while an STP generally helps one avoid a market peak and average costs, they are not a foolproof device. If the markets keep rising for many years, as they did from 2003 to 2008, and then fall sharply, then even an STP cannot eliminate losses. Equity is equity and there’s no way of doing away all risks. However, based on what has happened over the last two decades in India, stretching an investment over two to three years is likely to capture enough of a market cycle to significantly reduce risk.

At the end of the day, the key question that an investor has to ask is the trade-off between the risk of short-term equity market gyrations and the long-term returns that one can generate from equity. A lump sum investment is weighed completely towards the former, while a period like two to three years is a better trade off. And as for cycles that are long as well as extreme, like the one from 2003 to 2008, those are like a natural calamity. You can prepare for them, but there’s nothing that will keep you 100% safe.

Sachin Tendulkar started playing cricket at the age of 16. At 29, he has already amassed over 12,000 runs in one-day matches. On the other hand, Robin Singh joined the Indian team at the age of 25 and has retired now. He could manage only 2,336 runs in one-day matches. Before you begin to wonder if we have lost our marbles, let us tell you what we are trying to arrive at here. The idea is simple: the earlier you start investing, the more likely it is that you would end up making more money. While runs scored in cricket don’t multiply automatically, investment does. Surprised? Well, the fundamental principle of compounding helps you realise this.

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Let’s see how the concept of compounding works. Suppose Sachin started investing Rs 2,000 per year at the age of 19 and when he reaches 27, he stops investing and locks all his investments till retirement. Robin, however, doesn’t make any investment till he is 27. At 27, he starts investing Rs 2,000 a year till the age of 58. The adjacent table tells you how their investments would turn out when they both are 58, assuming that the growth rate is 8 per cent per annum. The results are eye-popping (see Compounding: A Tale of Two Investors).

What is compounding? Benjamin Franklin once wrote somewhere: ”’tis the stone that will turn all your lead into gold Remember that money is of a prolific, generating nature. Money can beget money, and its offspring can beget more.” Compounding is a simple, but a very powerful concept. Why powerful? Because compounding is similar to a multiplier effect since the interest that is earned by the initial capital also earns an interest, the value of the investment grows at a geometric (always increasing) rate rather than an arithmetic (straight-line) rate (see How Compounding Works). The higher the rate of return, the steeper the curve.

For example, at an annual interest rate of 8 per cent, a Rs 1,000-investment every year will grow to Rs 50,000 in 20 years. While at a 10 per cent rate of interest, the same investment will fetch you Rs 63,000 in 20 years. So, it is quite clear that a 2 per cent difference in the interest rate can make you richer or poorer by Rs 13,000. And, by staying invested for a longer period, your capital will earn more money for you.

Basically, compounding is a long-term investment strategy. For example, when you own a mutual fund, compounding allows you to earn interest on your principal. Compounding also occurs when you re-invest your earnings. In the case of mutual funds, this means re-investing your interest or dividend, and receiving additional units. By doing such a thing, you are earning a return on your returns and the principal. When the principal is combined with the re-invested income, your investment will grow at an increased rate.

The best way to take advantage of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.

Most of us want to reduce the tax outgo on our salary as much as possible. For this purpose, the investment limit of Rs 1.5 lakh a year, allowed as deduction from your income under Section 80C of the Income Tax Act, can play a large role. But that also means that a chunk of your annual savings has to be invested in these options, leaving very little surplus for other investments to build wealth. That essentially means that you have to invest smartly when you invest to save tax. That is, save tax and build wealth at the same time. But do you do that?

You can do this by diversifying your tax-saving investment basket and ensuring you have contemporary market-linked products that deliver superior returns in the long term. Under Section 80C, the typical investment plans for saving on taxes include your Employee’s Provident Fund, Public Provident Fund (PPF), the NSC, the five-year tax-saving deposit and tax-saving mutual funds. Then there are the pure insurance covers and investment-linked insurance plans such as ULIPs.

While the traditional options have their own advantage, tax-saving funds score over the other options on various counts. Before we move to the advantages, what exactly are these funds? They are simply diversified equity funds that invest in stock markets and additionally provide a tax deduction on the principal amount you invest, in the year of investment.

That means they are not different from an equity fund in terms of their investing objective or strategies they can adopt. Here’s how this class of tax-saving instrument scores over the other options:

Tax-saving funds have the shortest lock-in period (3 years), when compared with other options. That means post the 3 years, while you can stay invested, you will have the leeway to take out the money when you need it.
Tax-saving funds, being linked to equity markets, have proven to be superior returning options over the long term. Tax-saving funds have on an average delivered about 20% annualised returns in the last 3 years (category average returns as of October 7,2015). Of course, while they are also subjectto market vagaries, over the long term, their returns have proven to be far superior to traditional options such as PPF or NSC. PPF interest rates, for instance, have fallen from 12% in 1999 to 8.7% now. Clearly, fixed return products have seen a decline in rates promised, over the years.
Unlike options such as 5-year tax-saving bank deposit, where the interest income is entirely taxable, tax-saving funds, being equity funds, enjoy tax exemption on the long-term capital gain. That means the entire gain is free of tax. That means they enjoy dual tax advantage. One you enjoy deduction on the principal at the time of investment and then enjoy exemption on the entire gains at the time of sale.

Besides, the above advantages, tax-saving fund, like any other mutual fund, is highly transparent, with daily NAV declaration, monthly portfolio and factsheets and so on. Thus, you can always keep an eye on your investment.

Best ways to invest

It makes sense to start investing in tax-saving funds, early partof the year, through SIPs.

This way, you can average your costs in the equity market and also spread your investments lest you do not have sufficient surplus to invest. If you truly wish to average across market phases, continue SIPs for 3 to 5 years and claim every year the way you would do with your insurance premium or other regular tax-saving options.

Added to this, link some of your key medium to long-term goals such as saving for children’s education or your own retirement to these investments. That would help you save tax and build wealth