By Mehrab Irani
As an investor you may face different types of challenges in the current globalize world where the markets and investments are linked. As a fund investor, your life is even more complicated when you have to select between a plethora of different funds offered from various fund houses. You have an option of investing in open ended or close ended funds or equity, debt or commodity funds and many different categories within each of them.
Having said all this, which is the best category of fund in there for you? Rather than looking at the positives of each fund, I will look at the different “investment robbers” and how each fund protects and guards you against each of them. The fund which protects you of all the Investment Robbers is the Fund which we are looking for you.
Investment Robber 1: Inflation
Inflation is one of the biggest and the most silent enemy of any investor. Infact, it is that monster which many investors don’t recognize. Many people believe in “saving money” and mistake it for investment. However, they don’t recognize and appreciate the important fact that “saving is not investing”. Never mistake saving for investments otherwise you will be in for a rude shock. You would probably be living in a big delusion because you don’t understand the rules of money. The rules of money permanently altered in the year 1971 when the then US President Mr. Richard
Nixon took the US off the gold standard and granted itself the license to print money. Since, then the US Dollar and other world “currencies” have depreciated while the price of all commodities measured against it be it precious metals like gold, silver or industrial metals like steel, copper, aluminum or agricultural commodities – all have gone up and will continue to go up over the long term. Hence, inflation is the Investment robber number 1 against which the fund has to protect your investments. Debt funds don’t offer any protection against this investment robber number 1 of inflation because bonds and money market instruments primarily invest for coupon interest or accrual which is not capable of protecting your money against deprecation in the value of money due to inflation because these kind of investments only offer current income and not capable of providing growth income which will shield your investments against the monster of inflation.
Equity funds certainly offer you protection from inflation as they are invested in companies whose earnings are supposed to grow. Also, gold funds would offer you such kind of protection because it is an inflation edge. But then do they protect you from the other investment robbers.
Investment Robber 2: Income Tax
The Government is the biggest investment robber of all who systematically and legally takes away money from your pocket at all the stages of your dealing with it, whether be it savings, spending, investing or insuring. Most of you would be recognizing the threat provided by the taxman but would not be aware of how to actually protect your money against it. Government puts one of the biggest dent in your pocket when you earn return on your investment as it conveniently taxes it. For example, interest on a bond is fully taxable in your hands at the marginal rate of taxation. As far as mutual funds are concerned, all the debt oriented products are taxed and hence pure debt funds will not protect you from this “Investment Robber 2”. Equity funds offer you that protection in the form of tax free dividends and long term capital gain exempt from the purview of the taxman, but then do they protect you from the other investment robbers.
Investment Robber 3: Interest Rates
Another big enemy of your investments are interest rates. Infact, interest rates are such a big enemy that it affects both debt and equity investments. When interest rates rise, bonds prices fall and so does the NAV of your Bond Fund. Again, when interest rates rise, equities as a general rule fall because the earnings of companies drop due to high finance and interest cost, equity valuations contracting due to rise in the discount rate and high interest rates results in reduced fund availability for equities as debt competes with them for the same investor’s wallet. Therefore, both debt and equity funds would not be able to protect you against this investment robber 3 of interest rates. Gold would in all likelihood able to protect you from the investment robber of interest rate but would it be equally effective against the other investment robbers.
Investment Robber 4: Market Volatility
Investment robber number 4 would be “market volatility”. Prices of all market determined products, be it equities, bonds or gold, would fluctuate and remain volatile with day-to-day price movements. Yes, the price of an accrual product like a liquid fund would certainly protect you against market volatility but then it would not protect you against investment robber number 1 “inflation” and investment robber number 2 “Income Tax” as well as investment robber 5 which is to follow. So which kind of investment has the wherewithal to save and protect you against the dangerous investment robber 4 of market volatility?
Investment Robber 5: Incorrect Asset Allocation
The importance of asset allocation can be understood by only one statistical fact which Ibbotson and Kaplan have shown that 90% of portfolio variability is due to asset allocation. This means that only 10% of the variability in portfolio performance is due to individual holdings while 90% of it is determined by how the funds have been allocated. Mr. William Bernstein has said in The Intelligent Asset Allocator that “there are two kinds of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know”. Therefore, a cardinal principle of investment is, which may seem bad news to many is that, the only thing which is in your control is asset allocation because that is what you have full control on. However, neither do equity, bond or gold funds offer you this kind of protection against Investment robber number 5 of “incorrect asset allocation”. Then who indeed does?
The Fund that protects you from all Investment Robbers
And the fund that protects you from all the Investment robbers is, any guesses, it is a simple age old fund called the “Balanced Fund”. Do not believe it? Confused? Let us see how a Balanced Fund indeed protects you from all the different Investment Robbers.
Protection from Investment Robber 1: Inflation – Balance Fund invest both in equities and debt. The equity component in the Balance Fund protects your money and investment from the big silent monster of inflation.
Protection from Investment Robber 2: Income Tax – Balance Fund is treated as an “equity fund” as far as taxation is concerned and hence on one hand its dividends are tax free while on the other hand it is outside the purview of long term capital gains tax. The beauty of it is that even the “debt portion” of it becomes tax free as equity which never ever happens in any other case.
Protection from Investment Robber 3: Interest Rates – Balance Fund invest both in equities and debt. The equity component in the Balance Fund protects your money and investment from the dangerous killer of interest rates.
Protection from Investment Robber 4: Market Volatility – Balance Fund invest in both equity and debt. As explained in my previous blog on “Investment Cycle” - when one asset class is in a bear market most probably there is some other asset class which is in a bull market. Therefore, a balanced Fund, as the name suggests, balances and evens out market volatility by providing you with the best risk adjusted returns with minimal market volatility.
Protection from Investment Robber 5: Incorrect Asset Allocation - This is perhaps the most important protection offered by a Balance Fund. As explained earlier, the key to long term superior investment performance is asset allocation and what can be better than a Balance Fund which has allocation to both equities and debt. Further, it always by definition buys the cheaper asset and sells the costlier one when one asset class out-performs the other so as to bring the fund back to the optimal asset allocation. Therefore, it automatically by definition follows the most important principal of investment – Buy Cheap and Sell Dear. To conclude, the name of the Fund is Balance but it is the most imbalance of all the funds as it takes the credit of protecting and shielding your money of all the five investment robbers. So the next time you see a “Balance Fund” don’t just brush it aside because remember that whether it is investments or life, a simple and Balanced approach always works. All the best in your balanced approach towards investments and life!
Mehrab Irani is the General Manager – Investments with Tata Investment Corporation Limited. Kindly visit his blog: www.intelligentmoney.blogspot.com. His first book titled “Memoirs of My Articles – A Golden Collection” is available over here http://pothi.com/pothi/book/mehrab-irani-memoirs-my-artciles-golden-collection. His second much awaited book titled “10 Commandments for Financial Freedom” is releasing shortly. He may be reached email@example.com.