The Art Of Selecting A Financial Product

Most people invest with little or no in-depth analysis or study. What are the factors that must trigger your investment? The article provides guidelines from an investment product perspective and can be used for buying any financial product, including your insurance. Keeping all these points in mind while selecting your financial product will help you to improve your chances of generating wealth

There is a dichotomy in the behaviour of most of us. Before buying a new mobile phone we visit all the possible websites trying to figure out different features of the required mobile phone and its price. We even go to the length of reading all those reviews which are barely readable with naked eyes and finally after talking to a trusted friend we take a decision on buying a mobile phone. Nevertheless, when it comes to buying mutual fund or insurance or stock or most of the financial products our most trusted partner is our bank relationship manager or an insurance agent or a broker who is an expert in giving tips. The reason for such contradictory behaviour is primarily due to lack of knowledge of different financial products and not being interested in knowing more about them. To help all such readers, we bring you a quick checklist of things to look into before buying a financial product.

Returns
Returns is the single most important factor for which you invest. You sacrifice your current expenditure to enjoy its fruit sometime in the future. For this sacrifice you require returns. There are different ways of measuring returns. It needs to be analysed with the right perspective so that you can take informed investment decisions. All returns beyond one year should be annualised. The purpose of annualizing is to standardize the investment period as though each investment was made only for one year. This enables easy comparison of investments across various time periods. All annualized returns are represented as ‘per annum’. Secondly, these returns should be adjusted for tax.

Here, post-tax returns matters and not the absolute returns. Say, for instance, currently the best returns that you can get from a bank fixed deposit are around 6 per cent for a period of five years and more. This does not look exciting at all and if you add the tax component in it, the returns will look further dull and dumb. The fixed deposit (FD) interest is taxable at your slab rate along with applicable surcharge and cess. For example if you have a total income of Rs 15 lakhs per annum, you will be in the 30 per cent tax slab. Assuming your FD interest is Rs 50,000, it will face a tax of Rs 15,000 (excluding any cess or surcharge). Continuing with the above example, your rate of return will be only 4.2 per cent on FD rate of 6 per cent.

Another way round is when you get tax deduction in case you invest in certain securities including tax saving bank FDs for five years and equity-linked saving schemes (ELSS). To arrive at returns on your investment you can add the savings on tax to compare it with other investments. Lastly, your returns on investment should be greater than the rate of inflation. For instance, if inflation is higher than the interest you earn on your investment, then you might just end up losing money due to reduced purchasing power and there is no need to sacrifice your current expenditure. Therefore, to protect your purchasing power you need to invest in securities that earn you post tax returns greater than inflation.

Risks 
It may sound like a cliché but return and risk go hand in hand and are directly related. Higher the return potential, higher might be the risk on that security. Risk is mostly related to the fluctuations in the value of your investments or any other kind of risk in the financial product. So understanding the risk element in the financial product and how the overall value can go up and down is very important. Last year was the best example to know how the extent of fluctuation in asset price can happen. The equity market plunged by almost 40 per cent from its latest peak in less than two months. More dramatic was its recovery. In the next nine months it recovered all the loss and went ahead to touch a new high. So understanding the risk element in the financial product and how the overall value can go up and down is absolutely essential.

For example, in the last one year on an average, small-cap funds have generated returns in excess of 100 per cent. It will appear very promising and you may assume that your investment will grow exponentially. Nevertheless, if you look at the returns beyond one year, you will get the context of such returns. From the start of year 2018 these companies has been underperforming and were down by 55 per cent. So the current outperformance is helping it to revert to mean returns.

Expenses
You might have experienced or heard a lot of time about the ‘hidden cost’ of a product. Nonetheless, they are never hidden. The problem is that you never take that extra effort to unearth or find out such cost that keeps on eating your returns. How long does it take to find out the cost structure of a product? Very less! Most likely, a product will have its brochure on the internet. Download the PDF brochure, go through it and locate the costs. You will mostly see all the costs related to the product, whether it is insurance, mutual fund or any other financial product. 

There are three stages when a cost is incurred while taking any financial product. First is at the entry point. When you buy a product you pay entry load. In case of mutual funds there was entry load earlier but that has been removed now. When you buy equity shares directly, you pay brokerages. Now as you are invested, there is a cost of staying invested. For instance, there is a running cost which is charged when you invest in an MF. This is deducted from your net asset value (NAV) itself.

In case of ULIP you pay a cost as a deduction of units. Also, equity MFs can charge a fund management fee of up to a maximum of 2.5 per cent of the asset under management per year. For equity you need to pay annual maintenance charge. Lastly, when you exit from the product you have to incur expense. For example, in case of MF if you exit before one year from equity-dedicated funds, they normally charge around 1 per cent of your exit amount. For debt-oriented MFs, it can vary as per the exit period. For equity investment of ETFs you have to pay brokerage.

Liquidity
This is one of the most underrated factors when one goes for selecting a financial product. The term liquidity in finance refers to the time and the cost it takes to convert an investment into cash. This becomes critical when you discover how illiquid the product is in an emergency. It is essential to give some consideration to liquidity and not have all your capital tied up as you may encounter the need for urgent cash at any time. Mutual funds are very liquid and depending upon the category of the fund, you can convert your investment into liquid cash within three days or a week. Even in case of equity if you have not invested in some illiquid penny stocks, it will get converted into cash in two working days. Nonetheless, in the case of some products such as contribution towards pension, liquidity is an issue and you should be aware of its liquidity structure to plan your finances better.

Purpose
Last but not the least, before selecting any financial product, the purpose for which you are committing your fund should be clear to you. Many of you simply buy insurance not for risk management but because someone presented it to you as a great investment idea. Nonetheless, insurance can never replace your investment and you may choose a sub-optimal product not solving the purpose for which it was bought. In case of mutual fund investment too, if you assign it to a goal before you start to invest, it will help you to remain focused and committed. For example, if you have started investing in a fund and have assigned it to your child’s education, chances are very low that you will use it for any other purpose. While if no goal was assigned you could use it to upgrade your car or even go for an international vacation. Hence, always assign a purpose to your investment even if it means creation of wealth.