Budget – FY21: What to do with your insurance, investments under the new tax system

The Budget for FY21 (April 2020 to March 2021) has brought a new tax system with a reduced rate and favorable slabs for those who are willing to let go of the exemptions. See this to find whether the optional tax system is beneficial for you.

If you have decided to opt for the new system, most of the exemptions given to tax-saving investments/insurance products currently do not apply to you. Both Insurance and Investments are important aspects of one’s personal finance plan and this shouldn’t be abolished because of a change in tax rules. That being said, if you are already investing in certain kinds of products just for tax savings, this could be a good time to review and make changes to benefit you.

The most important rule remains the same under the existing system or the new system. Tax saving shouldn’t be an objective, it should be an incentive. It means one shouldn’t take an insurance product or start an investment just for the sake of tax savings, for example, a good tax saving investment should be a good investment first! see below on what to do with existing Insurance and investment plans under the new tax system.

Insurance

One should always have health insurance and one with financial dependents should always have life insurance, irrespective of the tax incentives. It is a common practice among Indians to invest in endowment kind of hybrid products, which does not offer good returns or adequate life cover. Most often, these are taken in a hurry in March by sales push, justified by the tax savings of these products under section 80C.

What to do: consider switching to term insurance plans for life cover. For the same life cover, term insurance premiums are a fraction of that of endowment plans. You may switch to a new term plan with adequate life cover*1. Use the difference to start investments of your choice. You will save a lot with a simple investment + Term insurance combo compared to an endowment/money back plan with the same life cover*1. If one is not comfortable with equity investments or planning to invest for the short term, do invest in Debt based mutual funds or traditional bank fixed deposits. If one is planning to invest for the long term, consider equity-based mutual funds. Do mind the penalties of exiting insurance policies prematurely. In general, exiting them in the initial years have been net beneficial even after considering the penalty.

Investments

The key point here is, whatever you do, do not stop investments just because there is no longer a tax exemption for investments. See below on what to do with the most common tax-saving investments under the existing system.

Tax Saving bank FDs: A tax saving FD is locked in for 5 years. Both tax saving FD and normal FD are taxed the same during interest accrual, hence one may invest in normal FD instead of Tax Saving FD. For favorable tax treatment during the investment and at the time of redemption, consider Debt based mutual funds.*2

Public Provident Fund: PPF is not taxed during the course of investment or at the time of withdrawal. This makes a case of investing in it in the new tax system as well (for anyone who is not comfortable with equity-based investments*3).

Equity Linked Savings Scheme: ELSS funds are similar to Diversified (Multi cap) Equity mutual funds, ideal for long-term investing. The limitation with ELSS is, every investment in it is locked for 3 years. If you think you have selected a good performing fund and you are happy with the performance, you may continue to invest in the ELSS funds, otherwise, you may do your fresh investments in Diversified (Multi cap) Equity mutual funds.*4

Conclusion

Personal finance planning is more important than tax planning. Decide your insurance requirements, identify your financial goals, plan your investment requirements, once this is completed, select suitable products considering any tax incentives. Make this change in tax rules – a reason to review your personal finance. Make it worthwhile, a plan focusing on you rather than the taxman or salesman.

Happy investing 👍

*1 If you have financial dependents, Consider starting a term insurance with adequate life cover, which is around 10 times your annual income

*2 Interest accumulated in a bank FD is taxed every year, irrespective of whether the FD has been closed or not, interest has been paid or not. The interest is taxed at the rate of tax slab of the investor. In the case of Debt mutual funds, no tax is applicable until the investment has been redeemed. At the time of redemption, if the investment has been held for 3+ years, Debt mutual funds are eligible for long term capital gains, which is 20% and calculated after indexation (adjusting for inflation) which again causes less tax outgo for most of the investors (depends on tax slab)

*3 PPF is a debt-based long-term investment product. Ideally, any long-term investment product should be equity-based. Even though equity mutual funds have capital gain tax at the time of redemption, historical data suggests an investor is likely to be better off with post tax return of an equity-based mutual fund compared to PPF.

*4 Valueresearchonline fund selector https://www.valueresearchonline.com/funds/selector/ is a good tool to compare among multiple fund categories.

Should you opt for the new tax system? Budget – FY21

Budget FY21 (April 2020 to March 2021) has proposed a new personal income tax system with a reduced rate and favorable slabs. However, there is a catch. Exemptions and deductions*1 are not applicable in the proposed system.

Taxpayers will be allowed to choose between existing and new tax regime. So should you opt for it? It depends on an individual’s income and the exemptions he/she avail. See the worksheet below to find it out.

images

Note: Only 2 data need to be entered into the worksheet:

file

  1. Income – this is total annual income (not the take-home pay)
  2. Exemptions – the sum of all the exemptions and deductions claimed (or planning to claim). Example. For someone with ₹70k 80C investments, ₹50k housing loan principal repayment, and ₹60k housing loan interest payment, this will be ₹2 Lakhs

Conclusion:

For an individual, always personal budget is more important than the nation’s budget 🙂 In case you end up benefiting from the proposed tax system, consider using the extra income in hand (however small it will be) to reduce your debt or start an investment.

Happy investing/Debt reduction 👍

Read more: What to do with your insurance, investments under the new tax system

*1 at the time of writing this article, a detailed list of exemptions and deductions, which are not applicable in the new tax regime is not published. It has been notified that up to 70 exemptions will be removed.

Can you reach the moon by folding a paper 42 times? [compounding stories explained]

3 popular compounding stories will be explained in this article. See this article for another compounding story explained.

Story # 1 Can you reach the moon by folding a paper 42 times?

We have a rough idea of how thick a paper is, at least we know how thick a 1000 page book is. That being said, what would be the thickness of a paper, which is folded 42 times? Let’s start by doing groundwork:

The thickness of 1 sheet of paper = approximately 0.1mm

Earth to moon distance = 3.844 Lakh Kilometers

Thickness of paper folded one time = 2 X 0.1mm

Thickness of paper folded two times = 2 X 2 X 0.1mm

Thickness of paper folded n times = (2^n) X 0.1mm

Hence,

Thickness of paper folded 42 times = (2^42) X 0.1mm

= 4.398 X 10^12 X 0.1mm

= (4.398 X 10^11) mm

= (4.398 X 10^5) km   # 1km = 10^6 mm

= 4.398 Lakh Kilometers

We can see that the thickness of the paper is more than the distance to the moon.

graph3

Some milestones along the way:

  • By 7th fold, thickness crossed 1cm
  • By 14th fold, thickness reached around the height of humans
  • By 23rd fold, thickness crossed the height of Burj Khalifa
  • By 42nd fold, thickness crossed the distance to the moon

For more details, see the Compounding_stories, sheet ‘Paper folding’

Story # 2 Placing rice grains on chessboard squares, 1,2,4,8… etc

The story in a nutshell: Once an emperor agreed to give rice to a man as per the following rule: One grain is placed on the first square, double of that in the next and so on. Upon trying to fill in the chessboard, he came to know that this is an impossible task.

Again doing the groundwork:

The approximate mass of 1 grain of rice = 0.029grams

Number of grains on first square = 1

Number of grains on first 2 squares = 1+2 = 3

Number of grains on first 3 squares = 1+2+4 = 7

The sum of the series 1,2,4,8… etc upto n is (2^n)-1

Hence the number of grains on whole 64 cells = (2^64)-1

= 1.845 X 10^19

Mass of those grains = 1.845 X 10^19 X 0.029 grams

= 5.35 X 10^17 grams

= 5.35 X 10^14 kg # 1 kg = 10^3 grams

= 5.35 X 10^11 tonnes # 1 tonne = 10^3 kg

Now, to make sense of this number, the mass of an elephant is approximately 6 tonnes. The mass of total rice on the chessboard is equal to 8916 Crore elephants.

graph4

Some milestones along the way:

  • By filling the 6th square, the total mass is above 1 gram
  • By 11th square, total mass equals that of an egg
  • By 15th square, total mass is around 1 kg
  • By 21st square, total mass is around the mass of a human
  • By 28th square, total mass crossed that of an elephant
  • By 51st square, total mass crossed that of 1 crore elephants
  • By 58th square, total mass crossed that of 139 crore elephants (more than the population of India)

For more details, see the Compounding_stories, sheet ‘Chessboard’

Story # 3 For 30 days, ₹1 Lakh/day or ₹0.01, ₹0.02, ₹0.04, ₹0.08… etc?

You are given 2 options:

  1. You will be paid ₹1 Lakh/day
  2. You will be paid ₹0.01 on the first day, on the subsequent days, you will be paid double of what was paid to you in the previous day.

If you have to choose one of the options for a total of 30 days, which one will you choose? I am sure at this point, you’ll choose option 2 😉 anyway, let’s see the graph of net payments in both options.

graph5

Observations:

  • Until the 28th day, Option 1 was more beneficial. (Op#1 – ₹28 Lakhs, Op#2 – ₹26.84 Lakhs)
  • By the 30th day, Option 1 has paid a total of ₹30 Lakhs, while Option 2 has paid a total of ₹1.07 Crores.

For more details, see the Compounding_stories, sheet ‘Payment Options’

Conclusion

These compounding stories convey an important message: we do not have a natural understanding of how compounding works, we should use a Compounding_calculator than rely on our instincts if a situation involves compounding. It will help us to make better decisions. See the short story below:

Mr. A bought a plot in 1995 for ₹18 Lakhs, which was sold in 2020 for ₹1 Crore profit. Back in 1995, a bank was offering interest rates of 8% on 25-year deposits. What if he chose to invest in that bank deposit instead of purchasing the plot? (Ignore taxes)

Answer: He would be better off with the bank deposit as ₹18 Lakhs, invested at 8% for 25 years is ₹1.23 Crores (assuming yearly compounding)*1

 

*1 Banks usually follow quarterly compounding.

Does the fund manager keep 93% of profits? [compounding stories explained]

Minority_Mindset_Post

Recently in a personal finance page, I saw many people losing over the above post. They were asking for the math behind. This is one of those compounding stories where the final stage surprises us and seem to defy logic. Let’s have a look into this story.

So Does the fund manager keep 93% of profits?

Simple answer: No, Fee is deducted continuously and in this example, yearly fee is 2% + 20% of gains per year. suppose 20% is the gain for an year, fee = 2% + (20% of 20%) = 2%+4% = 6% for the year.

Explanation: The story is to emphasize the impact on final value over the long term due to lower returns. For example: at 20% growth, ₹1000 invested for 45 years is ₹36.57 Lakhs, at 14% it grows to just ₹3.64 Lakhs. Just 6% reduction in yearly growth caused a 90% reduction in final capital over 45 years.*1 Note that the focus should be on how less the investor is getting due to fees rather than how much the fund manager gets, which is a hypothetical scenario. 

Detailed explanation and math, also how the fund manager could make much more than the investor in a hypothetical scenario, continue reading.

We will start with finding yearly growth of Berkshire Hathaway. We know initial investment at 1965 is 1000 and value as on 2010 is 4.3 million. Applying this on a compounding calculator, we get yearly growth = 20.43%

pic-1

Explanation on hypothetical hedge fund charging 2 & 20:

If Berkshire was a hedge fund charging 2 & 20 fees, the investor will not be getting 20.43% compounded return for his whole investment as various fees will be deducted periodically.

2% is the fixed fee, which will be deducted from the total investor funds every year. For example, assuming at the time of fee deduction, if ₹1000 is the Investor fund value, ₹20 is deducted as fixed fee and ₹980 is remaining in investor fund.

20% is the fee on the gains in investor funds. For example, if the investor fund grew from ₹1200 to ₹1300 in a year, the gain is ₹100, of which 20%, ₹20 will be deducted as fee, investor funds remaining will be ₹1280.

To simplify calculations, the following assumptions are applied:

  1. ₹1000 is invested in the hypothetical Berkshire hedge fund in 1965.
  2. Assume Berkshire grew at exact 20.43% every year from 1965 to 2010.
  3. Both fees are deducted at the start of every year.
  4. The hypothetical hedge fund manager invests the fee deducted from investor assets into Berkshire itself under a manager account, earning 20.43%/year.

See the transactions for 45 years below:

transactions

see worksheet here

We can see that fund manager’s assets were above investor assets by 1978, in 13 years (see below chart: Log scale).

By 2010, investor fund is worth ₹3.47 Lakhs, while manager fund is worth ₹39.5 Lakhs.

Chart:

graph1

Chart (Log scale)

graph2

Why the investor and manager funds are not exactly 300K and 4m?

The main reason is because in this calculation, growth is assumed as exact 20.43% for every year between 1965 and 2010. In actual scenario, growth will vary year by year and accordingly, the fee deducted and fund value will be different. The explanation is to convey the gist rather than solving to precise numbers.

How did this happen?

There is no mysterious reason behind this, it is how compounding works. The manager fund was able to accumulate ₹39.5 Lakhs as he was constantly investing every year, increasing his per-year investments and getting a return of 20.43%. The investor fund was also able to accumulate ₹3.47 Lakhs, altogether, ₹1000 has became ₹43 Lakhs in 45 years.

Among some of the popular compounding stories: (first 3 explained in this article)

  1. Can you reach the moon by folding a paper 42 times?
  2. Does rice placed in all chessboard squares by 1,2,4,8… etc weigh as much as 8900 Crore elephants?
  3. Option#1 ₹1 Lakh/day or Option#2 ₹0.01,₹0.02,₹0.04,₹0.08… etc for 30 days?
  4. This ‘Berkshire hypothetical hedge fund story of 300k for investor and 4m for fund manager’

Even though the stories 1 & 2 has the most Wow factor (reaching the moon and crores of elephants), In my experience, people get more surprised by 3 & 4. I suspect the reason is, we take 1&2 as just some wonder stories with no connection to reality. Since 3&4 are talking about real money and hence more relatable, we feel it should match our current understanding of money and growth. When it does not; we get surprised or finds it hard to believe.

Sadly, this could also be the reason why someone is comfortable in locking in their money for more than 2 decades in products with very low potential growth, just because it gives tax exemption. 30% tax deduction at the moment sounds more important than earning more returns during investment period, how long that will be…

Conclusion

Albert Einstein said “compound interest is the 8th wonder of the world. He who understands it, earns it… He who don’t… pays it”. It is completely natural to feel surprised or suspicious on how compounding works. Whenever possible, use a compounding calculator to verify your instincts. 

Read this article for more on compounding stories

*1 In this particular example. For a different growth rate, impact could be slightly different.

The day you become debt-free…

We all know the struggle to pay off debts. Average employee with one source of income is likely to have 3 loans outstanding. Even after paying the EMIs, it feels like all the struggle is just to pay off interests and the principal outstanding hardly goes down. Soon it becomes a ritual to think only about somehow accommodating EMIs and stretch the cash balance to the next salary date. The day of becoming debt-free feels like forever in the future.

With the mere thought about debts draining so much mental energy, how can one create a plan to become debt-free? Here are some tricks to motivate you to stay on the course and likely to surprise positively in the medium to long term.

Debt Avalanche Method

In this method, you will focus on the debt with the highest interest rate. Minimum amount is paid to all other outstanding loans and the maximum amount is allocated to the highest interest rate loan, to close it at the earliest. Once the high-interest loan is paid off, the next high-interest loan is focused.

This method ensures minimum interest outgo, however, if the highest interest loan also has significant outstanding amount, this method may not feel rewarding.

Debt Snowball Method

In this method, you will repay the maximum on the debt with the least principal outstanding, irrespective of the interest rate. Minimum payment is done to all other loans and once focused loan is paid off, the next least outstanding loan is focused.

Even though this method is not optimized for the least interest outgo, it is likely to be more effective. As we see smaller debts being closed initially, it motivates us to stay on the course.

Tracking outstanding debt

This is not a repayment strategy. It can be done with Avalanche, Snowball, or your current course of action.

Tracking debt is simple. Just note down the outstanding principal on all the loans and enter it in an excel sheet on the first of every month.

How will this help with closing the loans?

We will see this with an example of Mr. A tracking his loans.

As of Jan 1st, 2019, Mr. A has the following loans outstanding.

  1. L1: ₹50 Lakh loan, 25 years duration, 9% Interest. EMI: ₹41,960. Principal balance: ₹49,44,218. Years remaining: 24
  2. L2: ₹7L loan, 7 years duration, 10% Interest, EMI: ₹11,621. Principal balance: ₹6,27,277. Years remaining: 6
  3. L3: ₹50,000, 3 years duration, 14% Interest, EMI: ₹1709. Principal balance: ₹19,033. Years remaining: 1

Assuming he pays all EMIs without fail, but no additional amounts, the tracking sheet for a year should look like below:

01

The total debt is reduced by just ₹1.6 Lakhs in a year.

Notice that one of the loans L3 is paid off by 2020 Jan 1. Mr. A’s EMI bill is reduced by ₹1709/month. Let’s see different cases based on what he does with this amount.

Case 1: Mr. A renews L3 with L4 of same EMI

Mr. A feels that the progress is not enough. Even after paying more than half a lakh every month, the total debt is reduced by just ₹1.6 Lakhs in a year. Meanwhile, he sees a new gadget, worth ₹50,000 that can be bought with a 3-year loan, 14% interest rate, EMI of ₹1709, same as closed Loan 3. He buys it (new loan L4) as he feels the total outstanding debt is too high for ₹1709/month to make a difference. His total monthly EMI outgo remains the same. Adding the new loan to tracking sheet, it should look like the below in a year from now:

02

After another year, total debt outstanding is ₹53.1 Lakhs, reduced by ₹1.2 Lakhs from the previous year when the L3 was paid off.

Case 2: Mr. A uses EMI freed up from L3 to payoff L2

Now imagine what if Mr. A didn’t take L4 at all and used the additional ₹1709 RS to pay off L2 for the whole year, see updated tracking sheet below:

03

See that the outstanding debt at 2021 Jan 1 is ₹52.53 Lakhs, reduced by ₹1.77 Lakhs from the previous year when the L3 was paid off, also ₹57,066 less than Case 1. Note that this happened by deciding to route a small amount of ₹1709/month to pay off existing loan instead of taking a new loan. I.e, by rerouting ₹20,508 for a year, ₹57,066 was reduced from potential outstanding debt.

OK, what about the positive surprise?

For that, let us project Mr. A’s case into 3 different possibilities:

Case 1: He takes fresh loans whenever an existing ₹7L or ₹50k loans are closed.

Case 2: When a loan is closed, he uses extra cash to increase monthly payments to the next loan.

Case 3: In addition to Case 2, he adds a small amount of ₹1000/month every year from his increments towards paying off loans.

04

In about 12.5 years:

Case 1: He has taken additional loans worth ₹16 Lakhs. He still has ₹41.43 Lakhs debt left.

Case 2: Same repayments as Case 1 but no additional loans were taken. He has only ₹14.94 Lakhs debt left. ₹26.49 Lakhs less than case 1.

Case 3: All the debt has been paid off.

Points to note:

  • Debt reduction does not happen in a straight line, it is likely to lose motivation in the initial years, getting into more debt, repeat cycle. Once the cycle is broken, Debt reduction is accelerated.
  • Even though it feels like the majority of EMI is going towards interest, not principal (especially in the initial years), for every additional rupee paid above EMI, the principal outstanding is reduced by the same amount, also it reduces interest on future payments.
  • To accelerate debt reduction, whenever a loan is closed, pay that much additional into an existing loan.
  • Every small step counts. Don’t think that a small amount is not going to make a difference. Increase your repayments with smaller amounts as soon as you get a salary hike. Remember this is also reducing outstanding principal and future interest payments.

Shift your focus from monthly payments to total debt outstanding. In the example, when Mr. A closed L3 and started L4, from a monthly payment-wise, there was not much change. He has closed a loan and will continue to pay the same total EMIs, however, from a total Debt outstanding perspective, he has reversed the last 5 months’ progress in that one step. See below:

05

Conclusion

When it comes to closing the loans, everyone knows what to do: Pay it off! Still we struggle to do just that. Debt is highly addictive. Often people stay in debt not because it is hard to pay off one particular loan, rather they keep on adding new debts and it becomes a way of life. Apply some mind tricks to motivate yourself to break the cycle:

Dream of the day when you’ll be debt-free.

Say out loud “one day, I’ll be working only for myself, not for my banker”.

In your tracking sheet, add some graphs, visualize trends.

Be happy with the progress you’ve done, however small it may be.

Whenever a temptation arises to fall into taking new-debt, say to yourself: By doing this I am undoing _ years and _ months of my progress on the day to be debt-free (you will get that year and month from your tracking spreadsheet)

If you can not avoid taking yet another debt, see if you can take a ‘break-year’ when an existing loan is closed but a new loan is taken only after a year. During the break year, an amount equal to closed loan EMI is used to prepay one of the existing loans.*1

Debt reduction is also important to focus on investments. When we start from -ve, we have to reach zero first to go into +ve*2

If you can do just one thing mentioned in this article, do track your outstanding debt every month.

All the best on your journey to Zero Debt!👍

*1 When you want to take a break-year after closing the only loan, invest in Liquid Mutual Fund SIP or Bank Recurring Deposit in the break year. When you need to take the loan, you can deduct accumulated savings from the break-year.

*2 If one has a housing loan with more than 5 years of payment remaining, it might be ok to keep the loan and start investments into equity-based mutual funds as housing loans usually have a lower interest rate and provides tax exemption. However, this will depend on the investor. If he is likely to splurge any savings, it might be ok to prepay housing loans.

 

A Simple Investment Plan for Beginners

Here is an investment plan with which a lot of newbies started their investment journey. Note that this is a general outline, that should help the majority. If you have any special requirements, check with your advisor and create a custom plan.

Details about each step have been provided in the notes below.

inv flowchart

Note 1: Repay your high-interest loans first before you start investing.

Credit card charges interest of upto 50% per year for the outstanding amount. Personal loans Interest rates are also in the range of 15 to 20% per year. It doesn’t make sense to pay this high interest on what you owe and earn lower returns on what you invest, hence those of you having these high-interest loans should plan to close those before starting investments. To read more on managing debts, see The day you become debt-free…

Note 2: Check KYC

KYC status can be checked from https://www.cvlkra.com/ > KYC Inquiry. If you have an active KYC, you should be able to start Mutual Fund investments online*1

Note 3: Docs for KYC

A first-time capital market investor should get KYC. Mutual Fund registrars -Cams https://www.camsonline.com/network.html, Karvy https://www.karvymfs.com/karvy/Generalpages/locateUs.aspx or your Bank should be able to get this done. The documents required for KYC are:

  • Address proof
  • PAN Card
  • Aadhaar
  • Cheque Leaf
  • Photo

The In-person verification is done along with the application.

Note 4: Emergency Fund

It is recommended to have an emergency fund worth 3 to 6 months of expenses. The emergency fund should be readily accessible. Savings Bank, Fixed Deposits with premature withdrawal facility, auto-sweep in accounts can be used for holding Emergency Fund. In the Mutual Fund universe, Liquid Funds and Ultra Short Term funds can be used for holding emergency funds. For a new investor, Liquid Funds are recommended. An investor holding emergency fund in Bank accounts may invest in liquid funds at once (lumpsum investment)

Note 5: Investing in Liquid Fund

If you don’t have an emergency fund, start building this regularly in a Liquid Fund. You may start a systematic investment plan (SIP) or make lumpsum investments as and when a surplus is available. If the investor didn’t have KYC already, a new investment form, along with KYC form should be submitted to registrars or Bank along with the documents. For investors those who have KYC, the investment can be done online*2

Note 6: Tax savings

Tax exemptions under section 80C is ₹1.5Lakhs. Use an income tax calculator https://www.incometaxindia.gov.in/Pages/tools/income-tax-calculator.aspx to see if you could benefit from investments under this section

Note 7: Investing in ELSS Fund

Equity Linked Savings Scheme (ELSS) is a type of Equity*4 based mutual fund, which allows tax exemption under section 80C. Investments under this category of funds will be locked for 3 years*3. Being an equity fund, it is recommended to invest regularly, instead of one bulk investment into this category (use SIP*5 instead of lumpsum). Note that a new investor can invest in both Liquid and ELSS funds based on his need for an emergency fund and tax savings. (On further details on what to do with ELSS funds after the lock-in period, do refer this article)

Note 8: Investing in an Aggressive Hybrid Fund

Aggressive Hybrid Fund (erstwhile Balanced Fund) is a fund category, which invests approximately 65 to 75% in equity and rest in Fixed Income*6. Because of the cushion provided by the Fixed Income component and inherent property of asset rebalancing, an aggressive hybrid fund tends to be less volatile than a pure equity fund. This is likely to be comforting for a new investor being onboarded. Just like ELSS fund, a new investor can start investing in the Aggressive Hybrid Fund along with a Liquid Fund. Note that Aggressive Hybrid funds are meant to be held for long-term (at least 3 to 5 years). Since an Aggressive Hybrid Fund invests the majority of its portfolio in equity-based instruments, it is recommended to invest via SIP, not lumpsum in this category also.

Conclusion

Waiting to make the perfect plan to start investment may prove to be futile, as one might wait forever. This is a simple, but not the only plan to onboard new investors. In the last 10+ years, I’ve seen a lot of newbies started with this plan and along the journey, they refined their plan to make amendments. One can start investments with as low as ₹500 and once the KYC procedure is done (which may take 15 mins), investments are just a few taps away on your mobile phone. Make a New Year’s resolution to start investing, take the first step to financial independence.

Happy Investing 👍

*1 Although one can start investments with ekyc, this has some limitations. It is advised to get full kyc for starting mutual fund investments.

*2 All mutual fund houses allow investments via their webpage. In addition to this, various platforms, registrars also provide this facility.

*3 Note that ELSS funds have the shortest lock-in period under allowed investments in the section 80C

*4 Equity portion of a fund is invested in tradable shares of listed companies. Equity will be volatile in the short-term but have the potential to deliver high returns, also beat inflation in the long term.

*5 In a Systematic Investment Plan (SIP), investor sets an instruction to invest a fixed amount into a fund at regular investments (usually monthly) for a predefined duration. This works like a standing instruction and no manual action is required till the SIP duration is completed.

*6 Fixed Income portion of a fund is invested in Debt-based securities. These are less volatile, however, long term returns are less compared to Equity Investments. A Debt portion should give returns comparable to a Bank Fixed Deposit.

Why do prices rise

Everyone has a basic idea of inflation. Prices do rise. Ever thought why? Let’s see with an example.

Once upon a time, there was a company The-company (TC) with 10 employees. It had only one client, the Only-client (OC). TC earned ₹1 Lakh/month from OC. TC had an association with a food coupon company, FCC. Every month upon receiving ₹1 Lakh from OC, TC will exchange it for 1 Lakh F-coupon from FCC and distribute it to the 10 employees at 10,000 F-coupons/head.

There was a hotel HT, near the TC and all 10 employees used to spend all their F-coupons at the HT. At the month-end, the HT owner will go to FCC and exchange the whole 1 Lakh F-coupons for ₹1 Lakh.

Let’s draw the transactions.

money

The cycle repeated every month, one day TC decided to hire an additional resource for R&D. TC asked for additional billing of ₹10,000 to OC, however, OC didn’t agree. When TC brainstormed on how to deal with the situation, someone said: “Since we’re paying employees F-coupons, not cash, we could still hire a new employee if we managed to get an additional 10,000 F-coupons”. TC talked to FCC on the possibility of this and FCC agreed to gave 110,000 F-coupons for ₹1 Lakh on one condition: They will reimburse F-coupons for cash only at the rate of 1.1:1 henceforth (which was 1:1 earlier)

TC hired a new employee at 10,000 F-coupons/month. Paid 1.1 Lakh F-coupons to all 11 employees. All 11 employees spend complete 1.1 Lakh F-coupons at hotel HT; When HT owner went to FCC at month-end, he came to know that F-Coupons are now exchanged for cash at a lower rate and he got only ₹1 Lakh for the 1.1 Lakh F-coupons he exchanged.

At this exchange rate of F-Coupons, HT owner will lose money and he decided to increase the price of all items at the hotel by 10% so that he will get 10% more F-coupons for the items sold and he can exchange the F-coupons for cash without a loss like last month.

Let’s draw the transactions once again.

money2

Now, if an employee is not aware of all these background stories, what among the below is he likely to conclude:

  1. Price has increased at HT
  2. Value of F-Coupon is reduced

Drawing parallels to the real economy

F-coupon in the example represents currency in real life. The story does not include a ton of real-life details to focus on a single point: when more currency is created, its value decreases.

From basic economics, supply and demand influence the price. If onion farms are destroyed by floods, the price of onions will rise as supply is reduced. This is simple to understand; however, even though we now have a large supply of almost everything we needed compared to previous decades, still on an aggregate level, prices have increased a lot. Could this be only because demand is increasing at a higher rate than the supply or something else?

One answer, which is rarely discussed outside economic groups is the quantum of the money supply. If more money is chasing ‘per-unit’ goods and services compared to the past, there will be inflation. In other words, if the supply of money is increased at a higher rate than the increase in goods and services produced, the value of money goes down.

To look into the actual numbers; as per the latest data (as on 18th Nov 2019); Indian real GDP (economic output) has increased at a yearly rate of 7.2% in the past decade, meanwhile RBI’s balance sheet has increased at the rate of 10.5% per year and money supply (M3) has increased at an even higher rate of 11.9% per year. (source: tradingeconomics.com) Even though it is not just the quantum of money, the velocity of money (the rate at which money changes hands) also affect inflation, we can conclude that the money supply does have a role in decreasing value of money.

Why the money will continue to lose its value:

Our modern economy is based on fiat money and fractional reserve banking

Fiat money means the currency we use is not directly backed by gold, foreign exchange reserves, or any other assets. It solely attains its value from supply and demand.

Fractional Reserve Banking system facilitates new money creation via giving loans. In a system based on this, a bank is required to keep only a fraction of the deposits and is allowed to lend the rest of the money. Suppose the banks are required to keep 10% reserves; If ‘A’ has deposited ₹100 in a Bank, then the Bank is allowed to lend ₹90, keeping ₹10 as reserves. If ‘B’ takes that ₹90 loan and spends it for purchasing something from ‘C’ and ‘C’ deposits that ₹90 into the same Bank, now the Bank is allowed to lend another ₹81 keeping additional ₹9 in reserves. Now the bank has lent a total ₹190 and it has ₹19 in reserves while the original deposit was only ₹100. Theoretically, this can repeat many times and the Bank can lend a total of ₹900 if someone originally deposits ₹100*1

Role of Central Banks and Government in money creation:

Just as an individual with ₹100 income and ₹110 expense will have to borrow ₹10; our government also has to borrow as its income usually fall short of expenses. As of now, India’s GDP is around $3 trillion and its government debt is around $2 trillion. Indian Central bank’s balance sheet is around $267 billion currently, in addition to that, the central bank also holds $448 billion in foreign exchange reserves. A peculiar case of central banks buying government bonds (thus lending money to the government) or foreign currency is that, unlike individuals, a central bank does not have to earn money to make these purchases. It can create money at will. Economists call this ‘creating money from thin air’.

If central banks are creating all this money, why haven’t the value of currency collapsed yet? The answer depends on an individual’s perspective. Do you think ‘losing 87% of value in 30 years’ a massive erosion? Do you think 7% inflation in a year is not that severe? Both are the same. India’s average consumer inflation is 7% per year, thus Rupee has lost 87% of its value in the past 30 years*2. Going forward, if inflation is just 5% per year for the next 30 years, Rupee will lose another 77% of its value. 

It is fair to say that our modern economy is dependent on is ‘continuous devaluation of its currency’. Although a sudden devaluation will hurt any economy, the absence of inflation will decelerate economic activity and affect the government balance sheet. This could be because of many reasons.

  • With deflation (negative inflation), consumers may be incentivized to hoard money and postpone purchases in the hope of buying things cheaper later. This pulls down demand and hurts businesses which are dependent on consumers buying their products.
  • Businesses feel confident of new investments and hiring if they have pricing power (ability to increase the price of their products) This increase in prices of goods is inflation for the common man. In the absence of it, businesses will cut back spending and hiring.*3
  • Inflation facilitates wage growth. It allows higher wages, as the additional cost can be passed on to consumers via higher prices. In the absence of inflation, companies will be reluctant to raise wages.*3
  • Due to inflation, The Government can repay existing debt with cheaper currency. E.g. if Government owes ₹100 and value of rupee decreases, Government does not have to compensate for the loss of value, it still needs to pay ₹100 itself (along with any interest originally agreed upon, which is not dependent on any rise in inflation after the issuance) Contrary to this, Government’s tax revenue usually increases along with inflation as most taxes are a fixed percentage of prices (or wages)*4

As deflation or even low inflation is detrimental to a modern economy. Central banks will step in to bring back inflation, read ‘devalue its currency’. Usually, it is done by reducing interest rates, reducing reserve requirements, etc. To see up to what extent they can go to bring back inflation, see Quantitative Easing and Negative Interest Rate Policy

Enough economics, what’s in it for me?

As an individual saving for the long term, always be aware that inflation is here to stay. The impact of inflation is dramatic in the long term as it compounds. At 7% inflation (which is average inflation for India in the last 30 years) a sample Item costs ₹100 today will cost ₹761 in the year 2049. If you think inflation is likely to go down in the future, be aware so do interest rates. The central bank sets interest rates based on inflation and at low inflation rates, retail deposits will likely earn very low returns. Below are some tips on financial planning.

  • Don’t find comfort in retirement/long term saving products offering a predefined nominal pension or lump sum returns in the long term as you can’t assume the value of the currency in mind.
  • Don’t feel satisfied by the 7.9% Interest offered by PPF- this rate is revised quarterly, hence it will be reviewed 60 times during the tenure of 15 years. It is not the nominal rate of return, but the rate of return over and above inflation is what determines whether you’ll keep the purchasing power of your invested value in the long term.
  • For long term investments, prefer equity-based investments, which has the inherent nature of generating returns above inflation.
  • Use financial calculators which account for inflation for all your planning as accounting for inflation is not something that we can do in our mind.

Conclusion

Some economists call inflation “the hidden tax” it constantly reduces the value of existing rupees. One can not fight for a world without inflation as then it will be a fight against our established system. Luckily for investors, with proper understanding and planning, they can be prepared to face inflation. With advancements in healthcare and rising life expectancy, it will not be unusual to have 30 or even 40 years of retirement life for many of us, this makes planning to mitigate inflation risk paramount. Many retirees unaware of the long term impact of inflation has learned it the hard way. Make time to understand and mitigate the risk of inflation, which is here to stay whether we like it or not.

*1 Assuming all the money lent has been deposited bank into the bank. In actual scenario, these deposits will be happening in different banks, however theoretical maximum lending value across those banks will be the same for a specified rate of the reserve requirement. Even though this new money created via loans are retired during loan-repayment, the loan repayment is completed in a long time and during that time, new loans will be issued, the quantum of which will usually be higher than the net loans repaid

*2 When a central bank goes overboard with creating money, people lose ‘trust’ in the currency and it starts losing value at an accelerated pace. This might prompt the central bank to create even more money to meet government finances and this creates a vicious loop. This is known as hyperinflation. Many economies have faced hyperinflation from time to time, Zimbabwe and Venezuela being the recent ones. Compared to these, the Indian central bank and government have done a commendable job, even at the worst of times, India managed to avoid hyperinflation, though there were many periods of very high inflation.

*3 There are exceptions to this. Businesses can also increase production, hire more or raise wages in some cases like innovation-based or technology-based productivity growth, which allows increased volume production, hence revenue growth without the need for a price increase. Example: mid-range mobile phone makers.

*4 Although it may sound like govt is benefited by high inflation; no conclusion should be made by a single observation. Very high inflation will disproportionately affect the poorer section of the society, they will cut back discretionary spending and promotes a case for social agitation. To compensate for this, the government will usually have to step-up social spending, which will negate any advantage it gained from high revenue.