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Risk Analysis of investment: Real Estate vs Equity

You must have heard people saying: investment in real estate is risk free. Stocks may crash, but real estate always goes up in price. After all, they aren’t making any more land, are they? You might also have heard, from the same people or different, that stock market investment is nothing but gambling. Let us today try to find out how real estate and equity shares really compare in terms of risk. Like this guy was confused about the returns comparison of real estate and equity, are some others confused about risk comparison of real estate and equity?

One thing is certain: real estate prices are actually less variable than share prices. The reason for this has 2 aspects:

1. Stocks are in themselves useless to a retail investor, who is unlikely to hold more than 0.001 percent of any decent company’s stocks. He has negligible voting rights and even less awareness. So, at any sign of trouble, stocks are sold en-masse and hence their prices crash.

2. Houses, on the other hand must be lived in, trouble or no trouble. One residential abode per family is almost essential. So, when there is economic trouble, people stop buying new property but they won’t sell their own home. This partial clinging to real estate makes its prices more stable than stocks.

Now, when financial “experts” speak in their confusing jargon, they call variability of prices as “risk”. This is misleading as, in colloquial usage, risk is a word that is used to convey a related but different concept. Let me point out risk factors that real-estate investment has even after a lower variability of prices. All this is for a middle class family, and these risk factors may not be applicable to rich people. An example middle class family headed by Mr. X will be our protagonist.

Object Diversification

Object diversification in this context refers to investing in multiple different objects. It reduces risk for the investor because different objects might give different returns: positive or negative; so that overall returns are relatively stable. By committing less than Rs. 3000 a month, Mr. X can invest in about 5 well-rated mutual funds and hence have exposure to shares of about 75 companies. These companies do varied business like banking, mining, refining petroleum, newspapers, construction, power production, consumer goods etc. Some companies will be big, some small. The highest exposure to any company he will have will be less than 5%. That is to say, even if that company mysteriously vanishes from the face of the earth(an unlikely event, to say the least) he will lose less than 5% of his money. A mere Rs. 1000 per month more, and he can invest in international equity mutual funds and buy so much diversification as is not possible to describe in this small blog of mine.

Mr. X can buy only one house per half-century. Diversification is just not possible. To have similar diversification as of the above share portfolio through mutual funds, he will have to buy a commercial complex in Kolkata, a small residential house in Mumbai, a mine in Jharkhand, a second larger residential house in Gorakhpur, agricultuaral land in Tamil Nadu,  and many more. He has to remember to buy buildings built by different builders. Forget about ANY object diversification: Mr. X has bought just one house, one location. If it is discovered (an unlikely event, to say the least),  that a volcano will erupt at the place soon, he will be severely impacted financially. Even a simple thing as the city water supply board quoting problems in supplying water to the area might impact real estate prices of the area. Such are the perils of ignoring object diversification.

Time Diversification

Time diversification means investing in a single object at different times. If the price of the object keeps changing, this technique can average out the overall investment price for the investor, thereby reducing risk. In investment arena, this can be achieved by, e.g.  SIP. The tubes of the internet are already choking with information about SIPs so I will not go into further details. The point is, through the years when prices of shares dance to the tunes of FIIs, Governments, International events etc., Mr X buys shares every month. So there is no risk of buying the full portfolio when the prices are at their peak.

I have said before, and I will say it again: Mr. X can buy only one house per half-century. Asking him to buy a house every month would have been funny, if it weren’t so inconsiderate. We will not advice anything of this sort. If this house purchase is done at a time when real-estate prices are near their peaks, bad luck. The long term returns from real estate appreciation will be reduced if initial purchase was at peak prices. Note that like every one else, Mr. X thinks he can time the market but actually he can’t. Since in this case since time diversification is not possible, he will try to time the market and fail. Moreover, price of the house is just part of the cost. Mr. X has taken a loan for 20 year, during the course of which he will pay more as interest than as principal . If he is paying peak prices for house, he has to proportionately pay higher for interest too.

Leverage

Being in the middle class, Mr. X does not have enough money in the bank to buy a house unless he finances it with a housing loan. This makes his real estate investment a highly leveraged one. Leveraging in any business increases risk. Many books have been filled with details how leveraging increases risk, I will only give a few links.

Fraud

Haha. Property developers are masters of fraud and of subsequent litigation. Project cancellation with non-refund, project delays, cost escalation, non-standard and confusing methods for size calculations are routine tactics of real estate business. Realtors encourage their buyers to go to court because they know it will be decades before any meaningful justice can be provided to the buyers. Realtors have lawyers in their employment whereas the buyers would be unable to afford the services of lawyers for long.

Mutual funds are regulated by SEBI: the second best regulators of India in my opinion (best is RBI). There haven’t been many instances of mutual funds (SEBI registered ones, of course) denying, or delaying redemption significantly. Upstream, in the stock markets, whenever we have a Harshad Mehta, Ketan Parikh, or Satyam, we improve our regulatory procedures so that similar occurrences are not repeated.

Fraud is the aspect of risk overlooked by most financial experts. Of course, when their definition of risk itself is different from the common man’s definition, such misunderstandings are bound to occur.

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Home loan tax deduction is/maybe no more

One of the best things that I like about the proposed new direct taxes code in India is the lack of home loan tax benefits. Without much delay, let us start cracking with the advantages of doing away with such stupid laws.

The following points, when taken together, prove that home loan tax breaks do no good to the country, or its common people. If anyone was served by such laws, it was the builders and the bankers. Let me demonstrate how.

1. Lower tax rates compensate for lack of home loan tax breaks. It is as if everyone is getting more than the full benefit of home loan tax break, without taking a home loan.

2. Leverage: Home loan tax breaks encourage taking home loan even if you can save (partially or fully) for buying the house. Or if buying a house is more trouble than it is worth for you because of the mobile nature of your job, so you prefer renting. Encouragement of loan taking leads to over-leveraged consumer behaviour, similar to the US sub-prime mortgage trouble. Read up on the dangers of over leveraging here and here. Since home loans are very long term loans, there is the added risk of interest rates rising a lot which can even double your EMI and thus break your back.

3. Lower housing prices: Removing tax breaks for home loans would bring down housing prices. It is the simple concept of demand and supply. Today, people select a house based on the (EMI – tax break) they can afford. When tax break is no more, they will select a house based on the EMI they can afford. This brings down the demand price. The lack of tax break will mainly affect the margins of builders. As we know, builders are no cuddly teddy bears who cannot take care of themselves. Between the white, black and all colors of money they earn, they can better take care of themselves than any of their buyers or employees.

This point is complicated, read carefully. The absolute amount of money in the hands of consumers is higher because of lower tax rates so real estate prices may not come down in absolute terms. But relative affordability of houses as compared to, say, cars/stocks/clothes/food/travel will increase because there is no tax deduction just for paying interest on a home loan.

Initially the builders will try to maintain the high margins by delaying projects and reducing the quality of buildings. So the buyers will have to remain cautious in buying newly built houses for a while and check the quality thoroughly before buying. But we need to do that anyway. See a video by a Unitech customer here.

Upto a few weeks ago, I had assumed that the Government will never be able to defy the powerful builders’ lobby and such tax breaks will remain forever as evils of Indian democracy. But my faith in Indian democracy has been restored to a small extent. The Government has at least proposed to do away with tax breaks for home loan. Well done ministers / babus / everyone involved. I think hon. Finance Minister Pranab Mukherjee should not get all the credit for this, as hon. former Finance Minister P. Chidambaram and team had started work on this code and it might be his legacy.

Dangers of this proposal:

1. The biggest danger is, of course, of the Government surrendering against the real estate lobby and re-introducing the stupid home loan tax deduction.

2. Since the builders have cash to burn and the power to wait out, people who want to buy a house in next few years might not get the full benefit of lower house prices. Hence they might have to make do with lower quality house than if they waited a few years for house prices to react to this news. Eventually, of course, no one can beat demand and supply.

3. Of course, the price of your house may be less now for the same reason: the buyer of your house will not get any tax break for taking a home loan to buy it. But I guess it is a very small price to pay for more affordable housing for everyone, including your future self and your kids.

Related post: Risk Analysis of investment: Real Estate vs Equity

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Why you don’t need a financial planner

I have nothing personally against financial planners. The few that I have met are amiable fellows. I also don’t say you necessarily don’t need one. Your circumstances might demand that you might need financial planning services. Read on to find out more about it.

Accountability

The results of many financial planning services will be visible only in the long term. Hence it is difficult to choose a financial planner based on performance. Financial planners themselves don’t come up with any metric against which they can be judged and held accountable. In such a market, the following traits will make successful financial planners and you are more likely to go to and trust one of them:

1. Marketing: A financial planner who markets and sells himself well will get more business. They will seem trustworthy, professional and reachable. They build a brand for themselves which you are happy to associate yourselves with. Read any sales, marketing and branding book for details, but surely, none of these techniques concentrate on improving performance or quality of service.

2. Persuasion: Once you consult a financial planner, his manner of speech, the confidence he exudes and general ambience of the environment come into picture. If the overall experience was convincing, you are not likely to take a second opinion and you will choose this same financial planner the next time you need advice. Note that this also has nothing to do with quality of service or prudence of following the advice.

As there is currently no way to hold financial planners accountable as to the quality of advice, the above described qualities are the secrets to success for any financial planner. None of them bode very well for you. This brings us to our next point:

Trust

Even if you define a good financial planner and manage to find such a person, how much can you trust them? That he was really a good financial planner you will know only, say, 40 years later. Remember it is your own financial future that you are entrusting to them. If the advice was wrong, the planner can shrug his shoulders. But you will know about it, 40 years later when you are truly and royally screwed. The solution: backup financial planner’s advice with your own research. This brings up the next point:

Cost

Given the limitations of a financial planner and inevitability of own research, is the financial planner worth the cost? Can he be replaced with more research? Or do you think you will take financial planning service to validate your own findings and give direction to further research?

Notable Exceptions

Now that I have made all financial planners call up Chhota Shakeel to cut my ticket, let me also mention these notable exceptions:

1. Sudden windfalls

Your grandma left you a fortune, you found potfuls of gold coins when digging a well in your backyard, you won “Kaun Banega 3 Crorepati” when your annual income is less than or much less than 50 lakhs a year, etc. You really, badly need a financial advisor. Why?

a) You are not used to handling so much of money. All your knowledge about managing money is for the amount of money you normally deal with. It maybe that those ideas hold for the windfall money, but maybe they are not.

b) You are too excited to make good decisions yourselves.

c) All your “friends” are asking favours of you. If you have a financial planner, you could say : “well, I’d love to, but you know my financial planner is a tyrant and he just doesn’t let me”.

d) Taxes. Some taxes are pre-deducted as TDS before you get your windfall. Some are not. Some taxes are due immediately, some are due before the financial year ends. Installments of some taxes might be due on next advance tax deadline. You have no idea. There may or may not be ways to save such taxes. A financial planner is indispensable here.

Even after I have told you, most people in these circumstances won’t use a financial planner. As my second point above says, you are too excited to make good decisions. Contacting a financial planner is a good decision that you will likely not make.

2. Short term debt management

You have developed a habit of missing credit card payments and are stuck in the vicious circle of debt. Or any other short term debt which you have unwittingly not paid for a long term. The financial advisor can let you know about ways to get you out of the cycle. This might include alternate avenues of credit, advice to lower expenses, tax-efficient ways to sell-off/mortgage your possessions and many more. Since it is short term debt management, you can objectively check the quality of advice given by the financial planner in a short span of time.

Note that I don’t include long term debt in this, because long term debt is like any other financial planning which you should do yourselves like I pointed out in the earlier part of this article.

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