Let's Understand Asset Classes
Did you know that if you only invested all your money in stocks you would get incredible returns over the long term? But what if you cannot stomach the risk where your investment could erode by 70% within a few months? Would you be able to sleep soundly if you found that your Rs. 50 lakhs investment became Rs. 15 lakhs? If you don’t like the wild roller coaster ride then you might want to diversify your investments into different investment baskets of varying risks. Generally risk is correlated with returns, so lower risk usually means lower returns too. To alleviate risk and to diversify, we need to understand asset classes. But what is an asset class anyway?
Wikipedia defines it as
An asset class is a group of instruments which have similar financial characteristics and behave similarly in the marketplace.
So an asset class has similar financial characteristics. A characteristic would be (but not limited to) return, risk, liquidity, taxation, lock in period etc. So if two investments have similar characteristics, for example, they give similar returns for similar risk and liquidity etc, then they belong to the same asset class.
There are several asset classes, but these are some of the asset classes that I think are important in India.
While it may not look like an investment, you need it all the time to buy anything. The cash sitting in your bank will give you very poor returns with the highest being 4%. But this is the safest and lowest risk investment. It is very liquid; after all you can buy things instantly with the swipe of your debit card.
Equities is the asset class that is popular for its high returns but at high risk. Basically you are investing in part of a company, and based on how the business does, and market conditions the stock may go up or down very quickly. This is the best asset class if you want good returns for your investments and you are willing to invest regularly for a long period of time. When I say regularly, I mean that you should not invest lump-sum amount in one go, but instead invest steadily every month. Don’t stop your investments or worse yet sell the stocks just because the market is down. And it is also important to stay invested for a long time, at least 5 years, ideally 10.
Equities also come with higher risk and volatility. So you may see your investment go up and down quite a bit. Equities are quite liquid and you can withdraw your investment anytime without any limitations or penalties (some mutual funds may have exit load if you sell within a specified period, usually 1 year). The tax is also quite favorable with just 10% tax on capital gains over and above Rs. 1 lakh.
India’s most favorite asset class and the one that I hate the most, not because it does not give good returns, but because of the way it is conducted in India. Real estate returns are generally good depending on luck and how the business is conducted, although the returns may not be as good as equities . If you know what you are doing, then this might not be a bad avenue to diversify your portfolio. The risk is high but again not as high as equities.
The liquidity is extremely poor. You cannot get back your investment quickly. You have to put up your property for sale, wait for a buyer and go through the registration process, all of which takes a lot of time. So not something that you can quickly convert to cash in case of emergencies. There are no investment or withdrawal limits. You can claim tax benefits on both the principle and interest part of your EMI.
Disclaimer: This is my personal opinion, it may not have happened to you. Personally I would not touch real estate with a 10 foot pole. There is a lot of black money involved in doing business with real estate. On top of that you have to bribe lot of corrupt public servants from the peon to MRO. And even educated well mannered individuals ask for cash when they sell a property. Just ridiculous. I have met only one friend who paid a premium for a property because he clearly told the seller that he would not give any black money. Rare to find such people. It is the same story when you want to sell. People will want to give their black money as cash. For all these reasons I would not recommend real estate asset class. Just buy one house to live in and live with the guilt of injecting black money and encouraging corruption in the system, knowing all too well that you cheated your country that one time.
Indians love gold and I am not sure of the reason. This precious metal has given good returns in the past but certainly less than equities, and it is very volatile. Its performance in the last 10 years has been very poor though. However, the main issue with this investment class is liquidity and safety. You cannot buy and sell gold easily. If you buy jewellery, there is wastage and you are not sure of the quality in spite of all the certifications you can get these days. Selling gold is even more difficult and will not give you the full value. Then there is the issue of safety. Where will you store all that gold?
I would not recommend investing in gold considering the risk vs return, liquidity, quality and safety considerations. If you still want to invest in gold and don’t need to physically touch them, then Gold ETFs may be for you.
This is the most famous and well known asset class. Fixed income could be further divided into fixed deposits (FD), employee provident fund (PF), public provident fund (PPF), national pension scheme (NPS), senior citizen saving scheme (SCSS), debt funds and a host of other schemes that governments tend to launch from time to time (Sukanya Samriddhi Yojana, Atal Pension Yojana, etc). All of these have slightly different tax treatment and liquidity, but they mostly have similar return and risk. Of these I would only consider debt funds and PF to be useful for people pursuing early retirement. Rest of them are too complicated from many perspectives including tax treatment, liquidity, investment as well as withdrawal limits and lock in period. If you are planning for early retirement, don’t bother with any of them. I will briefly describe why I consider some of them to be not very useful, but do note that your perspective may be different from mine, so take my thoughts with a grain of salt.
Fixed Deposits (FD)
I don’t have anything against FDs, but if you are in the higher tax brackets, the taxation will considerably reduce the returns from FDs. While they are liquid assets in the sense that you can break your FD prematurely and take your investment, you will not get the promised return if you don’t wait until maturity. So both in terms of liquidity and taxation it is inferior to debt mutual funds in the same asset class.
Public Provident Fund (PPF)
The lock in period for PPFs is 15 years (you can withdraw from 7th year onward with some limitations). The maximum amount you can invest is Rs. 1.5 lakhs per year. You can claim deductions of up to Rs. 1.5 lakhs under section 80C of Income Tax Act. If you are willing to wait for 15 years, why not invest in ELSS funds instead where you can claim deductions under section 80C and the lock-in period is only 3 years? While ELSS falls in a different asset class (equity), the risk is very low if you are considering being invested for 15 years anyway. However a couple of advantages of PPFs is that they are backed by government and completely tax free, while ELSS are linked to market conditions and the capital gains are taxable at 10% after Rs. 1 lakhs capital gain. But returns on ELSS are much better, and should more than offset the tax.
National Pension Scheme (NPS)
The lock in period for NPS is 10 years. And even after 10 years you are only allowed to withdraw 20% of the corpus before reaching 60 years of age. The worst part however is that you should invest at least 40% of the corpus in annuities after 60 years of age and the rest can be withdrawn. The corpus is tax free only up to 40% of the corpus and the rest is taxable. If you think this is complicated enough, there are a lot more rules which make it a very complex investment. I would never suggest any investment where you are not in control of when and how much you can withdraw. Especially if you are planning early retirement. This works for people who cannot do proper financial planning for their retirement and hence the government is doing it for them.
Senior Citizen Saving Scheme
This is an excellent investment vehicle except that it is available only for senior citizens as the name implies. You should be at least 55 years old to invest in it. Unless you are planning to retire early at 55 this is out of our reach.
There are more intricacies in each of the investment vehicles above, but I skipped them to keep it simple. Having said that, if you know what you are doing, go ahead and invest as you see fit. For my part, debt mutual funds and PF is the way to go. My suggestion is to always keep things simple. Our brain will suffer from choice overload when it is overwhelmed with choices.
If your employer offers PF, it is a fine investment since your employer also contributes to your PF. Moreover, PF is tax free and you can withdrawn 100% after 2 months after you quit your job. You can also claim deduction under section 80C. If your employer does not offer PF, or you are not maxing out on Section 80C, then go for ELSS but remember to invest periodically every month for at least 5 years to even out any market hiccups.
Debt Mutual Funds
This is where you should park your money if you want low risk (and consequently low returns). Debt mutual funds are not as safe as FDs but if you choose ultra-short term or short term funds and stay invested for a year or more, the returns are as good as FDs. Tax treatment is favorable too. The best part is that the investment is very liquid and you can easily manage asset allocation.
In summary, I would only consider investing in these asset classes – Cash, Equity and Fixed Income. And with in those asset classes, these are the investment vehicles I would recommend to keep things simple
- Savings Bank (cash)
- Equity Mutual Funds (equity)
- Equity Linked Savings Schemes - ELSS if you need to save taxes under Section 80C (equity)
- Provident Fund (fixed income)
- Debt Mutual Funds (fixed income)