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The Long Road To Prosperity

| 11/22/2010 1:08 PM Monday

Among the key decisions that every equity fund investor has to make is to choose between growth and dividend options. While both have certain merits and demerits, it is important for an investor to understand what exactly these options offer before zeroing in on one of them. Needless to say, one’s investment objective i.e., to receive regular income or capital appreciation or both would be the fundamental deciding factor.

Under the dividend option, an investor receives dividend as and when the fund has distributable surplus. As per the current tax laws, dividend from an equity fund is tax free in the hands of investors. Under the growth option, no dividend is declared and the NAV moves up and down depending on the market movement. Therefore, one pays tax only when one sells units. The rate of tax will depend upon the amount of time the units were held. Remember, a combination of selecting good quality equity funds as well as the right option can go a long way in achieving the desired level of success. Though more and more investors are becoming aware of the crucial elements while making decisions, there are certain myths that continue to cloud this process. The following are a few of the illusions that investors should steer clear of:

Aiming for immediate dividends
There are many investors who believe that investing in an equity fund just before the dividend payment is a smart strategy. Of course, the major attraction for them is the percentage of dividend as well as its tax free status. However, there are certain issues that you need to consider before making such an investment decision. First of all, it is important to understand that if a fund declares a 100% dividend, it is paid on the face value i.e. Rs 10 in  most cases and not on the NAV. Secondly, the NAV of the fund, post dividend payment, gets reduced by the dividend amount. For example, if the NAV of a fund paying a 100% dividend is Rs  40 on the record date, the NAV will come down to Rs 30, post dividend payment.

In other words, if the dividend percentage and not the quality of the portfolio or its composition becomes the main criteria, one may end up investing in a fund that may not otherwise merit an investment. It is important to understand that dividend payments by the funds are a process of distributing gains to their unit holders and only those who remain in the fund for a considerable period benefit from it in the real sense. Therefore, it is not advisable to make dividend as the main criteria for making an investment in an equity fund. Many funds will be declaring dividends during the next 3-4 months and hence investors would do well to resist the temptation of investing in these funds just to receive dividends in a short span of time.

NAV rise beyond one’s expectations
Many investors face the dilemma of how to react when the NAV of a scheme rises well beyond their expectations. The question that comes to their mind is whether they should wait for the fund to declare a dividend as that would allow them to book part profits or redeem all the units and reinvest at lower NAVs as and when the stock market goes through a correction. It is necessary for every investor to have a strategy in place to sell units like one has for making investments. If one invests to achieve the long term objectives but would like to maintain a particular asset allocation, one would be better off booking profits from time to time to rebalance the portfolio in order to bring the asset allocation closer to the desired level.

By opting for the dividend payout option, one can not only convert the short term capital gains into a tax free income but also book profits from time to time without having to worry about the right time to do so. However, the strategy of redeeming the entire holdings with an intention of reinvesting at lower levels may not be as effective as one can never be sure about the market movements in the short term.

 

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