Posts Tagged personalfinance

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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Efficient Market Hypothesis in India

Efficient market hypothesis says that stock markets are informationally efficient i.e. all publicly available information is already reflected in the stock prices. (Note that it is mostly illegal to use non-public information for getting advantage on the stock market.) Hence, no strategy can significantly beat the returns of the market (represented by indices) for a sustained time period. People, both professional and lay investor alike, make mammoth efforts in beating the markets, losing sleep over every movement of the market. The efficient market hypothesis, if true, would prove that all such effort is wasted and can at best equal the returns from passive index investing and at worst earn less returns than even the indices.

Studies to prove/disprove this hypothesis have mostly taken place in developed markets. Here, we analyze whether it holds true in Indian markets. Among the different types of people who try and beat the returns of stock market indices, a type that can be easily studied is mutual fund managers. This is because they have to necessarily provide information about their portfolios and their periodic returns due to SEBI guidelines. Mutual fund managers must beat the market indices to justify their high salaries and the expense ratios of mutual funds. It is believed that less than 15% , or 3%! of the mutual funds in the US beat the market indices, which is commonly used as an argument in favour of the efficient market hypothesis. Let us see how Indian mutual funds fare:

I will compare the long term returns of ALL equity diversified mutual funds and ELSS funds with a well known index. Funds for which such analysis is not possible will be discarded and reasons for doing so will be one of the following:

  1. Bonus issues by mutual funds: Date after last bonus issue will be considered. Bonus issues have gone out of fashion these days, so for most funds considered we can get such bonus free time periods of around a decade or so.
  2. Date of launch of the mutual fund: Only funds launched in the previous millennium (31 December 1999 or before) are considered so that we do not get dazzled by short term brilliance.
  3. Date of introduction of the index: In India, our indices are so young that we have mutual funds that are elder than Nifty by a decade or so. Still we can compare the performance of mutual funds against indices for a period of about a decade, so we will go ahead and compare with an existing index.
  4. Total returns: In regular indices, the dividends paid by the constituent companies of the index are not counted in returns. We have considered Nifty as the index for our purposes because its total returns index is readily available, which takes into account the dividend income as well. Since this data is only available 30 June 1999 onwards, mutual fund data of before this date has been discarded.
  5. Sector / Theme specific mutual funds will be discarded.

Following tables summarize our findings. The funds which have beaten Nifty are shown in green, those which lagged Nifty are shown in red. Data comes from Mutual Funds India. Returns have been considered starting from “Start date”, up to 15 July 2009 for the mutual fund as well as the Nifty total returns index.

Diversified Equity Schemes(all Growth/Cumulative option):

Scheme Name Start date Return from scheme (%) Returns from Nifty (Total Returns Index) %
BSL Equity 30/06/1999 1178.83 416.78
Tata Pure Equity 30/06/2000 472.47 332.77
Templeton India Growth 02/05/2000 651.73 367.63
HDFC Equity 30/06/1999 1316.3 416.78
Franklin India Prima Plus 30/06/1999 1070.69 416.78
Taurus Starshare 30/06/1999 598.16 416.78
Franklin India Bluechip 24/03/2000 523.58 314.09
HDFC Top 200 27/03/2000 518.97 315.41
Reliance Growth 30/06/1999 1766.29 416.78
LIC MF Equity 30/06/1999 225.91 416.78
Franklin India Prima 30/06/1999 1143.69 416.78
HDFC Capital Builder 30/06/1999 584.77 416.78
Tata Growth 14/07/1999 718.47 370.52
LIC MF Growth 30/06/1999 247.52 416.78
Taurus Discovery 14/07/1999 249.45 370.52
JM Equity 30/06/1999 283.31 416.78
BSL Advantage 23/03/2000 168.94 317.35
Reliance Vision 30/06/1999 1350.91 416.78
ICICI Prudential Growth 30/06/1999 695.17 416.78
ING Core Equity 30/06/1999 272.1 416.78
BSL MNC 28/12/1999 312.36 343.92
Sundaram BNP Paribas Growth Reg 16/05/2000 496.67 375.03

Equity Linked Savings Schemes(all Growth/Cumulative option):

Scheme Name Start date Return from scheme (%) Returns from Nifty (Total Returns Index) %

HDFC Taxsaver

06/04/00

747.82

338.08

LIC MF Tax Plan

30/06/1999

209.75

416.78

Franklin India Tax Shield

30/06/1999

1319.07

416.78

ICICI Prudential Taxplan

19/08/1999

852.5

367.65

These findings deal a fatal blow to the efficient market theory. Not only do about 70% of the mutual funds beat the market, many of them do so by a factor of 2 or more. Reliance Growth beat the market in this period by more than 400%. Note that the index returns considered are directly from the index and not from any index fund. If an index fund is used for investment, there will be some expense ratio of the fund and hence the index returns will be even lower than mentioned above.

This article is not intended to advertize mutual funds. Nor am I saying that mutual funds will necessarily continue beating the market by a wide margin. I have only analyzed the available data and come to the conclusion that Indian markets have not been demonstrably informationally efficient over the last decade. Hence stock picking has a lot of value in India. All the lost sleep over your stocks was not in vain, after all :).

Limitations of the above comparison:

  1. The comparison suffers from a survivorship bias. Which is to say, the funds which were performing very poorly were discontinued long ago and hence they do not appear in this study. Though in my defence, we have not seen a huge number of mutual fund schemes being discontinued, so possibly the bias does not invalidate my conclusions. In the US, only 15% or 3% funds beat the index even after a survivorship bias.
  2. A decade is not enough to get meaningful conclusions about long term trends. Here my defence is stronger. Efficient market hypothesis categorically denies the possibility of any strategy being capable of beating the market. As such, the onus is on the propounders of the hypothesis to prove that it is so. As market indices in India are very young, supporters of efficient market hypothesis also do not have enough data to be able to prove the hypothesis beyond reasonable doubt. All I claim is, the short term data that we have does not support the efficient market hypothesis.
  3. Maybe, NOW the markets are efficient and going forward it might get difficult to beat the market indices. Agreed. We can only say that so far there is no support for efficient market hypothesis in India. If you are reading this in year 2100 or more, maybe you can throw some light on this matter in the comments section.

Other problems with index funds in India:

  1. High tracking errors: Tracking errors as high as 10% are not unheard of, and fund managers have the audacity to justify the tracking errors. This proves that the index funds were started just to jump on the bandwagon but in essence many of the index funds are being actively managed.
  2. High expense ratios: Most index funds charge an expense ratio of about 1 – 1.5% which is outrageous. The exception is in ETFs (exchange traded funds) which charge around 0.5%. But even this is too high as there is not much that the fund manager has to do with an index fund and a lot of it can be automated by the fund house. Main reason to invest in an index fund is the low costs. In the developed markets, less than 0.25% expense ratio is charged for index funds. Hopefully as more money gets invested into index funds, fund houses will get a better economy of scale and expense ratios will come down.
    Chicken and egg: Index funds in India are not a good idea, partly because of high expense ratios, and expense ratios are high partly because not many invest in index funds because index funds are not a good idea.

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Appendix

More support about passive investing from developed markets:

http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm

http://seekingalpha.com/article/84916-percentage-of-active-fund-managers-that-can-beat-the-market-shrinking-rapidly

http://allfinancialmatters.com/2008/01/04/when-an-active-mutual-fund-manager-beats-the-market-is-it-luck/

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I don’t need Life insurance

Everybody and his dog will tell you that you need life insurance. I won’t even go into ULIPs as they are clearly devil incarnate. Even pure term insurance is not what everybody needs. I will summarize below the “reasons” people give for recommending a life insurance policy to you. Even though you don’t have any financial dependants. After a while, it becomes so irritating it is not even funny. The last “reason” is the best: even seasoned, intelligent, honest personal finance writers would tell you this one.

1. Tax benefit :

Are you for real? You get tax benefit on the money that you don’t even receive. It is like quitting your job to save taxes. Allow me to invent a sardar joke:

I once met a sardarji who was standing near a well and tearing and throwing 100 rupee notes in the well. I went to him and asked, “Sardarji, why are you throwing money down the well?”. The inimitable sardarji replied: “Bhai saab, for every 100 rupee note that I throw down the well, the government gives me 30 rupees tax break”.

2. You are worth it:

Yep, I am worth it. That is why I am spending it on a vacation in Switzerland. Or taking my girlfriend (earning well, NOT dependent on me in the least bit) to dinners inĀ  the Zodiac Grill, Taj Mahal Palace. NOT buying a stupid life insurance policy.

3. Premiums are lower if you start young:

Most unsuspecting suckers would fall for this. The beauty of this is: it sounds correct. And the real calculations are a bit complex. Not complex enough that you can’t do them but just enough that you get lazy and get suckered into buying a policy. If you don’t want to go into calculations, here is the crux of the counter argument: the premiums are ZERO when you are not insured. This is lower than any life insurance premium you will come across. These saved premiums can even be invested to earn you more money.

Since the calculations are “complex” you are too lazy to do them. But not to worry, I don’t call myself Business Pandit for no reason. Lets get cracking:

The example considered here is from SBI Life insurance. (The website of LIC is down today). There is this Mr. Sucker, 25 year old in 2009. No dependants. Question is to insure Mr. Sucker for Rs. 10 lakhs up to an age of 40 years(2024). He acquires a dependant (say, Mrs Sucker, and no, it’s not funny) when he is 30 years old(2014). Competition is between the following 2 ideas:

A. Get a life insurance at an age of 25 to take advantage of the “low” premiums. This is a policy for 15 years. Premium is Rs. 1954 per annum. Total premium Rs. 29,310.

B. Remain uninsured until the age of 30, and then get a policy for 10 years. Premium is ZERO for the first 5 years and Rs. 2150 for the next 10 years. Total premium 21,500.

Money saved with plan B is Rs. 7,810. This is not even considering that most of the money was saved in the earlier part of the plan which could have been invested. Skip the following block if calculations bore you.

Let us calculate the total cost of insuring Mr. Sucker in year 2024 rupees. Post-tax pre-inflation rate of return considered is 8%.
Cost of plan A = 1954*(1.08^14) + 1954*(1.08^13) + … + 1954

= 1954*(1.08^15 – 1)/(1.08-1)

= 53055

Cost of plan B = 2150*(1.08^9) + 2150*(1.08^8) + … + 2150

= 2150*(1.08^10 – 1)/(1.08-1)

= 31146

So in 2024 value of rupee, 53055-31146 = 21909 rupees are saved.

Philosophy:

1. Traditional media will not tell you the dangers of life insurance mis-selling. Life insurance companies are big advertisement spenders. Pissing them off is dangerous for any advertisement funded media (newspaper / magazine / TV channel / websites that write their own content). It is only some bloggers who will tell you the truth as we are not dependent on advertisement for our livelihood.

2. Yes India is severely under-insured. Yes we as a society need to encourage life insurance companies. No, this does not mean allowing 420 behaviour in life insurance.

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