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Wealth creation vs wealth preservation

Source : BUSINESS_STANDARD
Last Updated: Sat, Oct 26, 2013 18:41 hrs

The first step of a financial-planning exercise is to evaluate objectives and risk tolerance. Generally, investors start with products and tailor a plan around them - a case of the tail wagging the dog. Products should serve your objectives, not the other way round. Today's financial products cover real estate, equity, bonds, insurance, gold, commodities and other alternatives.

These asset classes need to be classified into two primary categories: wealth creating and wealth preserving. This distinction is important as the different objectives often get mixed up mostly due to clever product packaging. Of the choices available in India, only real state and equity qualify as wealth creators. Gold, bonds and alternatives must be employed to preserve wealth.



Real way to look at real estate
Real estate can create wealth if done as an investment. On the other hand self occupation shifts real estate from creating wealth to preserving it. Self-occupied real estate can take up a lion's share of savings of a common man. This is a real risk as self-occupation produces income only equivalent to savings on rent. In most of urban India, rental yields do not exceed three per cent.

Buying expensive property for self occupation is equivalent to investing a major chunk of your savings at three per cent. Capital appreciation is not applicable in this case as the intention is not to sell it, but to reside in it. This is one of the most popular forms of misallocation of capital. It results in great property and a stretched financial condition for the owner, with grave consequences to other equally important goals such as a child's education and a decent retirement kitty.

The worst part of self-occupied real estate is that, with each passing day, as property values rise, it becomes increasingly difficult to divest it. A better solution is to purchase property as an investment with a clear time line to divest, or to buy a smaller place than you live in at present so that as little capital as possible is blocked. More capital could then be freed up for more productive uses. As a rule of thumb, a place for self-occupation should be purchased with as much equity as possible to guard against the vagaries of the economic cycles, with sufficient capital left to meet other objectives.

Equities are better, if done right
Benefits of compounding to beat inflation over long periods of time and long-term capital gains make equity the best wealth creator in its class. However, caution must be exercised in selecting the right stocks and tracking them diligently.

If selecting and tracking stocks seems a challenge, as many investors have discovered in the past five years, investing in any benchmark (NIFTY)-indexed fund should serve to beat inflation when investing in equity. The indices have a survivorship bias, helping them weed out duds from time to time.

Bonds and gold help preservation
Gold is another popular investment choice for many Indians. Widely perceived as a wealth creator by a vast majority of Indians, it is at best a wealth preserver. A large part of the gains in gold prices that Indians experienced for 30 years (1980 to 2009) was due to the depreciation of the rupee against the US dollar, not because of any real appreciation in its value.

Besides, buying gold for jewellery leads to a 15-17 per cent drop in value due to making charges and government duties. This is difficult to recover in a resale. Gold should ideally be viewed as portfolio insurance and allocations restricted to less than 10 per cent.

Similarly, over time and if properly employed bonds and alternatives can act as wealth preservers. However, investors must be wary of trying to time bond markets too often to derive capital gains. This is no less treacherous than trying to time equity markets as many investors discovered a few months ago when the consensus bond trade went hopelessly wrong. Investing in fixed-maturity plans (FMP) might be a better idea to meet the objectives of asset allocation, though some deployment in short-term liquid funds is worth implementing.

While bonds are more tax-efficient than bank FDs, investors must be aware of the interest rate risk and default risk in bonds. The interest rate risk can be mitigated by holding the bonds to maturity; and, investors must be aware of the default risk inherent a high yield bond.

Similarly, tax-planning instruments such as insurance should not be viewed as a proxy for financial plans. Tax planning should not dictate financial planning because the objective of tax planning is to minimize tax outgo, while a good financial plan aims at maximizing post-tax income.

Alternatives (mostly hybrid structures involving multiple asset classes) on the other hand, while originally designed for wealth preservation in uncertain and volatile times, have been distorted to give the impression of the great new "risk-free" invention of modern finance. Often, the risk in these structures is never discussed. But the decision to invest in them should be done after a scenario analysis and an understanding of the risk in such structures along with their utility and impact on financial plans, instead of projected returns.

A financial plan should include three or four asset classes as the long-term objective is to secure consistent and risk-adjusted returns. In this regard the past performance of an asset class should not blind one to risk. Often, the best-performing asset classes constitute an extraordinarily large share in a portfolio. Such a strategy, more often than not, backfires with painful consequences.
The author is CMD, Angel Broking

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