For or Against NPS?

I had posted a few days ago, facts on NPS - it is available here.

Once in a few days, we would have got mail from NSDL saying to avail the additional tax benefit of Rs 50,000 per year under section 80CCD(1B).  So, if you are in 30% tax slab, it works out to a direct tax saving of Rs 15000 per year. So, it looks like Rs 15000 easy money.

But, just look at the the exit opportunity of Rs 50000 invested.

You can take out only after attaining age 60. And a mininum of 40% has to be invested in annuity. So, you can take out the lumpsum of a maximum of only 60%.  Out of 100%, 40% is tax free and the remaining is taxable at the appropriate income tax slab.

Let us say we take an annuity of only the minimum mandatory amount of 40%.

The split will be 40% taxfree lumpsum + 20% taxable lumpsum + 40% taxable annuity.

Two possible decisions:
1. Take the tax incentive and invest Rs 50000 in NPS
2. Do not take the tax incentive, pay Rs 15000 (@ 30% tax slab for the current year) and invest Rs 35000 in non NPS equity instruments (Long term capital gains being tax free).

For the ease of calculation, let us assume NPS and non-NPS investments generate the same CAGR over the years till the person reaches 60 years of age.  Assume the current investment becomes 10 times in about 30 years of time.

35,000 Non-NPS would have become 350,000 and this entire sum will be taxfree (assuming the current tax structure prevails after 30 years - big condition!)
50,000 NPS would have become 500,000
200,000 tax free
100,000 taxed at 30% = 70,000
200,000 annuity take which will generate just an inflation matching return beyond age 60

Current annuity table from LIC: https://www.licindia.in/Products/Pension-Plans/jeevan_akshay

@60 years of age, with return of capital, Rs 6600 is the annuity for Rs 1 Lakh purchase.  @15% service tax, for Rs 1.15 Lakh, annuity works out to be 5.74% - effectively just matching the inflation (and there is a possibility it might miss the inflation too in some years!)

And this will also be taxable.  Let us say, the annuity holder is still only at 10% tax bracket - then, net return is 5.74 * 0.9 = 5.17%  If the persion is in higher tax brackets beyond 60 years of age, the return further reduces.

@60 years of age:
Non-NPS is 350,000
NPS is 270,000 + 200,000 annuity

Effectively, the difference is :
Non-NPS is 80,000
NPS is 200,000 annuity with 5.17% return

Assume Non-NPS investment generates 3% higher CAGR - which is 8.74% and non-taxable.  At some point, the non-NPS will start accumulating more capital than the NPS one because of the higher compunding rate.
80000 * (1.0874) ^ (years) = 200000 * (1.0517) ^ (years)

It works out to be 27 years @ 3 percent better CAGR
It works out to be 18 years @ 5 percent better CAGR

NPS works out better if someone has an expectancy of around 80 years and do not foresee more than 5 percent better CAGR in non NPS investments (assuming LTCG in non NPS investments will be tax free)

All our analysis are based on our key assumption that till 60 years of age, NPS and non-NPS generate equal returns.  But, if the non NPS has compouneded at a better rate over the accumulation period till 60 years, then the scenario will be completely different with a tilt towards avoiding investing the tax incentivised NPS.

Mutual Fund Returns Calculator

I have published a SIP / SWP calculator, sometime back.  For now, it works with the Sensex data from Jan 1990.

The SIP calculator helps in calculating the CAGR / XIRR for
    1. Lumpsum Investments
    2. SIP Investments
    3. SWP Investments
   
SIP or SWP can be of daily / weekly / monthly / quarterly / yearly frequencies.

SWP is Systematic Withdrawal Plan where you have a corpus which is invested in an equity instrument (Sensex in this case) and from which a fixed amount is taken out at a regular frequency.

SIP - the assumption of calculating CAGR is that all the investments made at regular intervals compound at the same CAGR.

In SWP, if we have that assumption, then we also mean that the amounts taken out are reinvested at CAGR which may be an impractical assumption.  So, there is also an option given to modify the rate at which the withdrawals can be reinvested in.

Lumpsum / SIP / SWP calculator for Sensex

I am planning to update the calculator with the NAV values for Mutual Fund schemes - so it will be more useful.

MF Comparison Tools

Today, we shall see some tools which help in mutual funds comparison.

Morningstar's SIP Calculator - You can compare the SIP performance across three different funds.  But, it gives the performance review as on a particular date.  There are a few things that this comparator does not tell you:
1. How does a SIP perform across time periods, across different schemes?  This helps in selecting a scheme to invest in.
2. How will a daily or weekly SIP perform vs monthly or quarterly SIP?

FreeFincal (Dr Pattu) gives a rolling SIP returns calculator. He has a series of calculators on various components of personal finance!
https://freefincal.com/mutual-fund-sip-rolling-returns-calculator/
The way to interpret is this:  As on a point on X axis - say Aug 2013 (one of the lowest points of Sensex / Nifty), what would be my CAGR had I invested for the past 5 years (starting in 2008 Aug) and redeeming in Aug 2013?  It is 5% for rolling BSE Sensex.

Here, he compares the performance of several funds - HDFC Equity, HDFC Top200, Quantum LTE, IDFC Premier Equity against their benchmarks.  HDFC Equity and HDFC Top200 on the way to bottom, beats the benchmark - not good, losing more than the benchmark!  See Quantum LTE and IDFC Premier Equity - consistently beating benchmark and during the slide manages to lose less than the benchmark.

https://freefincal.com/nifty-200-dma-buying-high-vs-buying-low/
Here Dr Pattu analyzes whether there is an advantage doing SIP when the index (or the NAV) is less than the 200 day daily moving average vs index being greater than the 200 day daily moving average. The revealing and counter-intuitive observation is that the buying when the index is higher than the 200 DMA, the corpus is higher!

Systematic Investment Plan

SIP: Investing a certain quantum of money every month - in hope of accumulating a much higher sum in future.  An SIP is usually associated with the investment in mutual funds.  It is an MF version of erstwhile Recurring Deposit (RD).  Each investment in an RD can be treated as a monthly commitment towards a fixed deposit.  Let us say, an RD of 2 years, the first instalment stays for 24 months and the second for 23 months and so on - the last instalment stays for 1 month.  At the end of 24 months, the entire corpus collected along with accrued interest is returned to the investor.  The rate at which the interest will be accrued will be pre-fixed.  The first instalment generates interest for 24 months, while the last one generates interest for just 1 month.

A SIP in MF in that context is the same - you keep investing a fixed sum every month in a mutual fund scheme.  Except, there are a few caveats - which works well for investors with patience and may not work well for investors who are impatient.

There is no pre-fixed interest rate for SIP in MF.  By the way, there is no concept of interest rate at all, in mutual fund investments. If there is no interest at all, how does the corpus earns money?  On a daily basis, the mutual fund publishes Net Asset Value - NAV for all its schemes.  For an investment, units are allocated to investor based on NAV.  Let us say, the NAV of XYZ scheme is Rs 10.  An investor invests Rs 1000 today in the said scheme. 100 units are allotted to him.  Now, his money is converted into mutual fund units.  The next month, NAV falls to Rs 9.  Investor invests Rs 1000; 111.11 units will be allotted to him. Now after 2 months, his total units will be 211.11 and his Rs 2000 investment will be worth: 211.11 * 9 = Rs 1900.  So there is no guarantee that the investment will always travel upwards.  On the other hand if the NAV had risen to Rs 11, he would have got allotted 90.09 units and his total units of 190.09 will be worth 190.09 * 11 = Rs 2100

There might be very less chance of losing money in an RD in bank - though it might have lost the real value after accounting for inflation.  But there are good chances that a SIP, done for a shorter duration of time may end up less than the investment value.

At the end of RD, you need to mandatorily get back your amount - not necessarily the case in MF. You can keep the amount in MF to grow, even after the SIP period has ended.

Usually there is a penalty for premature withdrawal of RD.  Similarly, each investment of SIP has an associated exit load if withdrawn before certain period of time - the penalty percentage and the minimum commitment time differs from scheme to scheme.

By the way, RD is a product on its own; SIP is a way of investment.

CAGR - Compounded Annual Growth Rate is an important measure in determining how an investment performs over a given time period.  As on the day of evaluation, CAGR is the uniform rate which when applied for each instalment, accounting for the duration each instalment is invested for, would give the current amount - the total accumulated units valued at the current NAV. Sometimes, this CAGR is also called IRR or XIRR.

CAGR is one of the important benchmark in determining how the investment has fared over the years.  Though a point in time CAGR for evaluating mutual fund schemes is not so helpful.

Financial Calculator Suite

We earn and spend; Rinse - Repeat!  We really do not know how much it costs to earn and live, leave alone the needs for pursuing a passion!  As the income increases, the expenses catch up - unless planned.  Parkinson's law states "Work expands to fill the time available".  Similarly, the expenses increase to consume the income!  Planning is essential; setting aside an amount for future consumption is necessary.  People starting at age 25 and planning to retire at 55 have 30 years of work life and if they expect to live till 95 years, 40 years of retirement life. Assume there is no income in retirement, the 30 years of work life has to provide for 40 years of retirement!

It takes some math and compounding to estimate how much it is going to cost for expenses, when we retire.  To start with, one has to know what is the expense at the current level and how many years he has in his hands to retire and what is the contribution towards the retirement corpus that is going to be committed every year.

To help with such projections, I have created a simple application to help with the calculation.  This I call the "Calculator Suite for Retirement".  Consists of 3 parts:

1. Retirement Calculator: Projects the expenses and corpus and lets us know whether the current networth and the investment commitment till the retirment age will be able to provide for the entire life.

2. Annuity Calculator: Given a corpus and expected years for which the corpus is planned for, how much is the maximum annuity that can be withdrawn every year, assuming a given inflation

3. Corpus Calculator: Given a required annuity for a defined number of years at a set inflation level, how much is the corpus required?

Though I call it as a retirement calculator, this can be used for any defined goal - be it children's higher education, planning for a vacation, setting aside and building corpus for pursuing a passion, upgrading a house or a car - any such medium to long term goals.

Mohnish Pabrai TieCon Lecture

I watched another lecture by Mohnish Pabrai yesterday.

This was a talk on sales and marketing in TieCon Feb 2014.  The video was for one and half hours. Since it was a lecture, I did not watch it in full, but heard completely.  The full one and half hour was entertaining and captivating.  He started with how he initially thought of marketing was a jazzy or shiny or frivolous work and how his ideas changed after he read a few books by William Davido and Miller & Heiman in the late 1980s.  Those books are: Marketing High Technology, The New Strategic Selling, Successful Large Account Management and The New Conceptual Selling. Marketing is about the core value proposition that you put forth in what you believe.

The other books he mentions about are:
Power and Force - by Richard Dawkins - where he quoted on the idea of getting clues from sub conscious mind and keeping the communication channel (between the conscious and sub-conscious mind) free of clogging - so the message is sent across.

Origin and Evolution of New Businesses - by Amar Bhide - this is a research on the successful entrepreneurs and the best practices followed by them. Mohnish could relate to how he did his business with other people mentioned in the book - He gives his explanation of why he used the title "Vice President"

Tom Peters books: In Search of Excellence, A Passion for Excellence, Leadership

He has some very interesting anecdotes in the lecture.  His friend, then 19 years old, came up with the InstallShield software which was originally an after thought, non-buillt software listed as just a bullet point in a software exhibition at a conference.  A young person out from army, trained in making cables started a cable business, when he realised a demand, later went on to build a cable laying business.  These anecdotes he said on the necessity making things that customers want and of pursuing an idea wholeheartedly and changing it as per the needs of the customers and how the competitors evolve.

He says he is an expert cloner and never shies away in admitting the fact.  He shared his personal experiences of copying successful ideas (cloning) which he did in his business.  His experience in Mumbai with a jeweller who sent a greeting card every year - just to make himself remembered during a big wedding jewellery purchase - that made him to send cards to his customers.  A parcel he received from his law firm, where the organization name was written in extra large letters on the envelope - that made him to adopt a similar design for his business envelopes.  He says his Pabrai funds is a clone of Buffet partnership model which ran successfully for a decade till Buffet closed it in late 1960s.  He also says most of his stock ideas come from other investors.

Watch the video to experience!

Man's search for meaning

I have just started reading "Man's search for meaning" by Viktor Frankl, a psychiatrist and a II WW holocaust survivor. In the book, he writes about his experiences in the Auschwitz concentration camp and what made people to withstand and survive the terrible experiences - he says whoever had a "Why", a reason to survive had higher chances of survival than those who had lost hopes in between.  He willed himself of coming out and teaching psychiatry.  He chose to go to prison with his elderly parents, having his US visa lapsed.

He says: "Everything can be taken from a man but one thing: the last of the human freedoms; to choose one's own attitude in any given set of circumstances, to choose one's way".

There are multiple views of what makes a life: Life is a pursuit of happiness; Life is a pursuit of success.  In Viktor Frankl's view, life is a pursuit of meaning. And that meaning, the reason gives the life the support and balance to survive despite the circumstances.  If you have a "why", "how" does not really matter. He writes, "Life is never made unbearable by circumstances, but only by lack of meaning and purpose."

I have not completed the book in full. Will update more as I progress and finish.

My Financial Starter

I remember the first time when I got a job offer.  A software engineer job with a company based in Chennai with a good pay package. I felt it was a huge sum.  (It dawned on me later that it was not so big as I originally thought). My parents then, may not have been earning so much.  I was wondering what I would do with such a huge salary!  Once I joined the company, I wanted to plan my income tax and savings.  But, there was no body out in my circle of friends and relatives who could help with that. Adding to the complications, I changed my job in my first year itself.  I submitted all my investment proofs in the previous company.  The new company did not cut income tax for the few months when I worked. I was happy. Then, while filing the income tax, the auditors who came calculated a huge tax which I paid promptly - they were auditors right?  They must have calculated correctly!  The assumption was wrong.  The auditors added up the salaries at old and new companies and did not even take into account the investments I had made.  I realised it only later. I now consider that as a fee for learning how income tax filing works and a penalty for not doing my own tax returns filing.

There are some crazy things which I did in the first 2 years of my job.  Started a recurring deposit; bought some gold; bought a car in loan; opened a demat account and piled up around 30 different securities each for tiny sums; The craziest of all: Started a 6 month SIP! Adding to the list: 2 whole life LIC policies and another market linked one time premium ULIP from LIC apart from regular annual premium paying ULIP!

I was introduced to mutual funds by one of my colleagues.  He came with me to the nearest bank and helped me buy the first tax saving MF.  Later I opened a demat account and started trading in shares.  I bought mutual funds - so I know what shares to buy, right?  Again, wrong assumption!

It was not until after I finished my second tenure in college, I realised the importance of long term planning.

There are a lot of financial products available and not every thing is for everyone.  There are a few suited for some people which may be completely out of place for others.  And a few financial products are outright bad - helps the sales people and the product manufacturers at the expense of investors.  ULIP is the top name in that list.

As with the investment opportunities, are there the avenues and ways for expenditure.  Again, one needs to be watchful of mindless expenditure.  There are expenditure which people consider investments - this is a tricky trap.  If you expense on something considering it as investment, you are denying yourself an opportunity for learning as well.  Among these tricky traps are the expenses on car, car accessories, house purchase, house enhancements, mobile phones, laptops, bikes and many more!

How does a bank work?

A bank offers a number of  financial services among which, two are primary: It helps people to keep the surplus funds in safe custody and it helps people in need of money to utilise the money for a fee. The utilisation fee is called "interest".  A bank acts as an exchange between the "haves" and "have-nots" (usage not in the traditional sense) - As in modern times (with the traditional usage of the terms), it is the "have-nots" who keep the money and the "haves" who utilise that money - okay, leaving that aside.

Banks have to carry out the daily operations, pay the salaries of employees. Over and above, banks have to make profit to sustain in the business. So, they keep pocketing a portion of money that they get as "interest" from the borrowers and pay the remaining as the interest to the depositors. The depositors are of two types: "I want my money any-time when I ask" and another with: "Keep the money for 1 year, 2 year and give me at the end of the period" - The first category of people are the ones who keep savings account and current account with the bank - and because of the additional privilege of having money any time they need, the interest they get is typically lesser than the people who ask the bank to keep the money for a defined duration of time. Savings bank earn around 4% and there is no interest for the current accounts.  So, effectively there is a trade-off between higher interest versus liquidity. People would be willing to forgo a portion of their interest for the convenience of taking out money any time.  Between a savings bank and current account (the difference of 4% versus 0%), there exists a convenience premium for the current account holders to get money even when there is no balance left in the account (a facility called "over draft")

The Current Accounts / Savings Accounts (CASA) are the "demand liabilities" and the fixed period deposits are the "time liabilities" - Any deposit with a bank is a liability for the bank - it needs to pay back and also there is a continuous cash outgo from bank because of the same.

The borrowers take money from the bank for a fee which is ought to be paid monthly / quarterly or any specific period as agreed with the bank. Here again, the borrowers with whom the bank has enough trust in terms of past history or in terms of quality of the collaterals collected for the loan, get an advantage in terms of lower interest rate.  Borrowers with not so great credit background will have to pay more for the same loan, because the bank is taking an extra risk for which it needs to be compensated in the form of an additional interest.  When I say "high credit quality", it means the  probability with which the loan becomes a non performing asset (regular interest not being paid) is lower.

A bank cannot say to a depositor that 10% of its borrowers defaulted on the loan, so the depositors will get only 90% of the money. Because a bank offers such a protection, there must be a fee (which it gets in the form of interest rate difference between borrowing and lending) So, effectively, the depositors are lending to the borrowers with bank acting as an intermediary and taking the entire risk in the process.

What happens if some loans go bad? If the interest is not being regularly paid, beyond an acceptable limit, say 3 months, banks will treat the loan as non-performing asset (Means, loan is an asset for the bank because it generates the income - and since the interest is not being paid regularly - it is a non-performing asset). Once marked as non-performing asset, banks have to provision for the possible losses from the loan.  So, the provision takes a hit on the profit for the year. As bad loans increase, provisions increase. The sustained hits on profit later translate to a hit on the reserves and surplus, and slowly wiping off the equity capital of the bank, in which case the bank fails.

A bank is as good as its asset quality.

Primer on NPS

Quick Facts on NPS

NPS - New Pension System (also referred as National Pension System) is a contribution based retirement system promoted by PFRDA (Pension Funds Regulatory and Development Authority)

Tax Treatment:
Similar to PF, there can be contribution by employee and employer
Max contribution: 10% of (Basic + DA)
Employee Contribution: Falls under the limit of Rs 1.5 Lakh per annum - section 80 CCD (1), with other 80C schemes. (similar to how employee contribution of EPF is treated)
Employer contribution: 10% of (Basic + DA) is exempted under Section 80CCD (2) - this is beyond Rs 1.5 Lakh limit (similar to how employer contribution of EPF is treated) - i.e, not treated as income at all.
Additional Rs 50000 per annum (beyond Rs 1.5 Lakh limit) can be availed under Section 80 CCD (1b)

NPS has 7 fund managers to choose from - HDFC Pension Fund, ICICI Prudential Pension Fund, Kotak Pension Fund, LIC Pension Fund, Reliance Capital Pension Fund, SBI Pension Fund, UTI Retirement Solutions.

There are two accounts with NPS - Tier1 and Tier2.  Only Tier1 is eligible for tax benefits for investments.  Tier2 is more like an add-on for investor convenience.  Amount can be moved from Tier2 to Tier1 and not vice versa.

Amount contributed towards NPS gets invested in 3 different schemes - equity, corporate bonds and government securities. Investor can choose to invest in Auto mode or Active mode. Maximum possible contribution in equity scheme under both modes for any age is 50%.  Investor can choose to split the investments in Active mode, whereas in Auto mode the investment contributions get split as per investor age.  Rebalancing according to the target split happens yearly once on the date of birth of the investor.

The scheme details under each of equity, corporate bonds / govt. securties (E C G respectively) of Tier 1 and Tier 2 are available in the individual pension fund site
http://www.reliancepensionfund.com/navs/portfoliodetails.aspx?shortname=portfoliodetails
http://www.sbipensionfunds.com/portfolio-detail-system.html
http://www.hdfcpension.com/about-hdfc-pmc/investment-portfolio-details/

Minimum contribution
Tier1:
Minimum Number of times in a year: Once
Minimum Amount Contributed in a year: Rs 6000
Tier 2:
Once per year, Minimum Rs 250 (subject to a minimum funds available in Tier 2 of Rs 2000)

Fees
Minimum of 0.25% or Rs 20 per contribution (taken at the time of contribution)
0.0275% of funds under management for asset management, custodian and NPS Trust (adjusted in NAV)
Rs 190 per year for account maintenance taken by cancelling units in each of C, E, G

Withdrawal from NPS:
Possible only after age of 60
    A minimum of 40% to be utilized in purchasing annuity
    Maximum 60% can be taken as lump-sum
Premature exit
    Minimum 80% to be utilized in purchasing annuity

Taxation
    40% of withdrawal not taxable (only the available 20% lump-sum in case of premature exit)
    60% taxable - irrespective of lump-sum or annuity. Lumpsum taxable at marginal tax rate as per investor income slab for the year.
    Annuity purchase is not taxable, whereas the monthly payments from the annuity is taxable at appropriate slab.

Deferment of Withdrawal
    Defer annuity for 3 years
    Defer lumpsum withdrawal for 10 years
    Take lumpsum in a staggered manner in 10 installments.
    The entire withdrawal process can be deferred for another 10 years, during which contributions have to be made.

As of now, the following are the annuity providers from whom the annuity can be purchased.
    HDFC Standard Life Insurance Company Limited
    ICICI Prudential Life Insurance Company Limited
    Bajaj Allianz Life Insurance Company Limited
    Reliance Life Insurance Company Limited
    Star Union Dai-ichi Life Insurance Company Limited
    Life Insurance Corporation of India      

More Info:
    https://www.npscra.nsdl.co.in/all-citizens-faq.php
    http://www.hdfcpension.com/national-pension-scheme/nps-account/)

Now, analysis:
Assume a person of 30 yrs age is thinking of investing Rs 50000 (under extra tax exemption limit). He falls under 30% tax bracket.  He has 30 years time frame and two choices to make
   1. Go with NPS
   2. Pay tax and invest the after-tax amount in something similar
 
Let us assume the long term investment return over 30 years is 12% p.a.
 
Option 1:
   50000 * (1.12 ^ 30) = around Rs 15 Lakh
   40% withdrawal is tax free = Rs 6 Lakh
   20% withdrawal is taxed @ 30% = Rs 2.1 Lakh (after tax)
   40% withdrawal is utilized in purchasing annuity.
A quick look at  http://www.sbilife.co.in/sbilife/images/contentimages/AnnuityPlus_bi.htm shows that for a pension plan with refund of capital, the annual return works out to be 6.43% (after adjusting for service tax while purchasing annuity) pre-income-tax and 4.5% post income-tax at 30%   Rs 6 Lakh would give a monthly taxable pension of Rs 3218 and an effective post-tax pension of Rs 2252
 
Assume the person is living till 75 years of age and his hurdle rate is 10%. i.e he can borrow funds at 10%.
   With the post tax cash flows from annuity and his hurdle rate, this works out to be Rs 3.5 Lakh
   With 70 years life expectancy - this number will work out to be around Rs 4 Lakh.
   With 85 years life expectancy - this number will work out to be around Rs 3 Lakh
 
   @12% hurdle rate:
   70 years: 3.46 Lakh
   75 years: 2.94 Lakh
   85 years: 2.47 Lakh
 
   So, the total cash proceeds @ age 60 can vary from  6 + 2.1 + 2.47 = Rs 10.57 Lakh to 6 + 2.1 + 4 = Rs 12.1 Lakh depending on life expectancy and hurdle rate.
 
 
   Option 2:
   35000 * (1.12 ^ 30) = around Rs 10.486 Lakh (Assume 50% equity and 50% is is Corp / Gov bonds)
   50% Equity LTCG is tax free.
   50% C / G LTCH is taxable in indexed fashion. So, 5.243 lakh - 17500 = Rs 5.068 Lakh is LTCG, which is Rs 88250 adjusted for indexation.
   Tax payable @ 30% on Rs 88250 Lakh = Rs 26475
   Net Cashflow at age 60 = Rs 10.486 - Rs 0.26475 lakh = 10.221 lakh
 
There are some questions to be addressed.
1. What happens on the death of NPS investor before 60 years of age?  Will nominee have to pay tax - to what extent?
2. When NPS is deferred for 10 years till age 70 and contributions are made, what happens in the event of death.

40% is taken tax-free. 20% is taxed (Less 6%), 40% is taken as annuity which one never sees it again, except in the form of monthly pension - which is constant all through his life expectancy.  No way to increase or decrease pension.

Even, with current tax benefit, the positive side is around Rs 0.35 Lakh to Rs 1.88 lakh which in current terms with the same long term return (12%) assumed is around Rs 1170 to 6275

All this, assuming the current 30% tax benefit. And after accounting for the 2016 change in tax treatment (that 40% of NPS corpus at age 60 is not taxable).  Otherwise, NPS makes no sense at all.

Still, one loses the independence by locking in the money for long term and locking in by purchasing the annuity for even longer term (possibly)

Take away:
1. Do not purchase beyond 40% of corpus in annuity.
2. While choosing annuity option, go for annuity with corpus refund - otherwise it is too risky if the investor dies very soon after purchasing annuity.
3. Defer it by 10 years, then defer annuity by 3 years

Talks at Google: Mohnish Pabrai and Guy Spier

I wrote about reading the book Checklist Manifesto, a few days back.  The author Dr. Atul Gawande talks about his interview with Mohnish Pabrai, a renowned investor.  Mohnish Pabrai says that so many investing ideas pops up every day, which pumps up the adrenaline - but, as you put those ideas through a well prepared checklist, you would sense most ideas are baseless and may not be pursued.  I have heard about Mohnish Pabrai, but have not attempted to dig deeper.  Yesterday I saw one of the google talks where Mohnish Pabrai and Guy Spier (who has written the book "The education of a value investor") speak about their experiences.

On watching the video, I became a fan of Mohnish Pabrai!  What a clarity of thought, and what narrative style he possesses! He talks about his investment in Satyam in 1994 / 95 time frames and how in a span of 5 years, he has made his $10000 to 1 million+ and got back the same in USD, sitting in USA.  That is a 100 bagger for him.  He says when he looked at the financials in 1994, he sensed Satyam was massively undervalued.  The real estate it owned in Hyderabad might have been above the market cap.  On another opportunity, he says, irrespective of high valuation of PeopleSoft when he decided to make money out of that, and having not invested, created a back door entry in the form of selling PeopleSoft consulting / services and made a high margin business out of it, with effectively a negative capital!

He shares his experiences with an industrial psychologist in 1999 / 2000 time frame who provided him with his "owner's manual" and how it helped him in becoming better at his focus areas.  He recommends everyone to have an "owner's manual", by consulting with a trained psychologist! The personal experiences are candid and succinct. He also shared two of his failures where he came out of a stock in 3x or 4x multiples which eventually became more than 20x or 50x

Mohnish and Guy Spier successfully bid for Lunch with Warren Buffet in 2007 and in this video, they talk about the surprising fact from their perspective in that lunch.

This is a 2015 Google talks video.  After more than 1.5 years, it has hit only 28k views!  Strong recommendation to watch.

Comparison of MFs - 3 Year CAGR

I proposed how a point in time comparison of CAGR across mutual funds may not give much information.  Yesterday, we saw how the CAGR return distribution of 3 year, 5 year and 7 year in the same fund fared against each other.  Today we take a specific set of 3 funds - no recommendation - the funds have been in operation for a longer period of time.  UTI Equity Fund, Birla Sunlife Frontline Equity Fund, Franklin India Bluechip fund.  For these funds, 3 year lump sum investment CAGR is calculated for 7 years. For investments from Apr 2006 to Apr 2013.  So, the total number of data points would be around 250 * 7 = 1750 individual lumpsum investments.

A cumulative distribution plot is generated for the 3 funds which look like below:




Median return of BSL Frontline is better than UTI Equity which in turn is better than Franklin India Bluechip. And if you look at y=0.25 line (at 25%), we get that 75% of returns are upwards of 9% in UTI Equity and upwards of 8% in the other 2 funds.  Take the y=0.75 line, 25% chances that the returns are around 16% in Franklin India Bluechip and around 20% in the other two funds.

To view in terms of returns, for a 15% or above return, BSL Frontline has a 45% chance (1 - 0.55) and 38% chance with UTI Equity, 33% chance with Franklin India Bluechip.

In general, the curve on the right is better - for the same return you get a better probability. In a real scenario, we would never get these lines running parallel, so you can choose the one on the right most!

Equity is a long term investment

We recently saw that it may not make so much sense taking a single point return (as on a particular date).  Instead of looking at a MF scheme page and assuming it gives a CAGR of 12%, 14% and 13% respectively for 3, 5 and 10 years, how about actually getting a sense of how the return distribution looks like over a large set of data.

Here, I have tried to plot the return distribution for a large cap equity fund.  The data is taken from AMFI website.  The data is available only from 2006. I have taken 7 years data (making up for around 1750 data points) for 3-year lumpsum investment, 5 years data (1250 data points) for 5-year lumpsum, and 3 years data (around 750 data points) for 7-year lumpsum investment.

Here is the graph that we get:

Red, Green and Blue represents the 3 year, 5 year and 7 year return distributions respectively.  Some points to observe: The returns are not negative (no loss of capital) in the 5 year and 7 year investments - but be aware that the data points considered are less and may not even cover one investment cycle or business cycle.  But, the 7 year investment would have had investments made in the high of Jan/Feb 2008 and redeemed in Jan/Feb 2015.  Still, it did give a positive return.  There is 75% chance (observe the horizontal line of y-axis=0.25) that the CAGR is minimum 9% in 3 and 5 year lumpsum and 11% in 7 year lumpsum. Median CAGR is 13%, 12% and 13% respectively, means there is a 50% chance that CAGR is minumum the median amount.

25% chance that the CAGR is minimum 16% in 5 year and 7 year lumpsum investments and a minimum 20% in 3 year lumpsum investment.  Also, see the shapes of the curves.  The 3-yr red curve deviates widely compared to green (5 yr) which deviates more compared to blue (7 yr).  Means, the volatility in terms of observed CAGR increasingly gets reduced as the holding duration increases.

The dataset taken is very minimal but you get the idea. Equity is for long term. Better to hold for a longer term!

In next post, we shall see how we can use this for comparing mutual funds.

Reading an MF scheme overview page

If you visit any MF scheme page in one of the consolidation websites like morningstar or valueresearchonline, you would see something like this.





So, this page gives a comparative performance of the fund with respect to the benchmark and category in several time buckets - Year To Date, 1 Month, 1 Year, 3 Years, 5 Years and 10 Years.  This also gives the rank of the fund in the category and total number of funds in the category.  For instance, in this example, I have taken a mid cap fund.  The percentage within one year are absolute return percentage and beyond one year are CAGR - Compounded Annual Growth Rate. You would also see the growth of Rs 10000 in the said period of time.

But, please make sure that you are not selecting an MF scheme to invest in, based on this page.  Though this seems to give performance across time periods and across funds, neither is true.

Make a strong point in memory that all the numbers that is quoted in the page are as on one particular day - here it is 18th Nov 2016.  And the growth of 10000 or the percentage numbers are what you would have got if you had invested before 1 yr, 3 yr, 5 yr or 10 years.  So, it is all hindsight information - may or may not become valid in the years to come.  The numbers and ranking will be different if you see the page after a week or month.

And you never know against which funds are you comparing. Some funds may exist in 5 year time period and may not be present in the 10 year time period. i.e it would have commenced between 5 and 10 years ago.

A better benchmarking for a 3 year return would be to get a view of how a 3 year return distribution is across some 3 or 5 years.  To get a 5 year of 3-year return data, you would need data points for 8 years and to get a 5 year distribution of 10-year return data, you need data points for 15 years.

Checklist Manifesto

Just finished reading the book "Checklist Manifesto" by Dr. Atul Gawande.  The author is a specialized surgeon practising in Brigham's and Women Hospital, Boston.  The book, in essence, elaborates the importance of having a checklist in routine practice, especially in situations where the stakes are higher - like flying an airplane or surgery.  He describes how he got the idea of having a checklist for surgery and how such a checklist is already in practice in several fields - from an artist performance, restaurant chef to aviation.  In aviation, such a checklist has been in practice since 1930s. He takes us through his initial trial of checklist in surgery and how he failed, later how he got the checklist fine tuned and made better taking inspiration from aviation.  Dr. Gawande gives a very detailed note on several case histories in both aviation and in surgery.  The narrative style with which he tells the story is interesting and got me hooked.  Some of the surgeries he described in the initial few chapters - thrilling!

Making an error and forgetting about having made the error is common. Having a checklist helps in accepting that fact and helps in taking precautionary steps the next time.  The examples from investing - Mohnish Pabrai, Guy Spier and categories of investors in the venture capital area depict how having a checklist helped the investor prevent errors and in several occasions making faster investment decisions.

The author takes us through the WHO initative on preventing the avoidable errors, checklist proposal and a test trial run in hospitals in 8 different cities across the world for 3 months and how having a checklist helped reducing surgery related complications and deaths significantly.  The way he looked for the counter evidence once he got the initial reports of the test trials is an antidote to typical confirmation-bias.  He goes and analyses whether the surgeries in trial period is less complicated, whether there is a Hawthorne effect etc.

In the process he meets several people - a restaurateur, a construction site builder / architect, investors, aviation experts.  He gives a complete narrative of a fine dining restaurant with several dishes is managed for an evening dinner for about 150 guests, how a high-storied building is constructed - work alignment and communication being the key, how team work becomes very crucial in surgery and aviation and how the checklists are designed to improve communication and team work.

The author is a surgeon, but the intricacies of account on building construction and aviation, where enough time spent in the book makes us go to the construction site and also fly with the crew and passengers and experience the thud of aircraft crash landing and the chillness of the icy water after one such aircraft landed on the water.

Mutual Fund Portfolio Scanner

Ever wondered what are the constituent stocks in an MF? This public disclosure is available in individual mutual fund websites.  This disclosure also gives information about how many shares of each stocks they hold in a scheme, the market value and weight of each stock in the scheme based on the market value (all, as at the end of previous month). Money control and Morningstar collates for various schemes across mutual funds.  For example, to see the detailed portfolio of Kotak Select Focus Regular Growth in

Morningstar
Moneycontrol

Let us say, you own 5 different mutual funds - may be one ELSS, one balanced, one mid cap, one liquid fund and one multi cap fund. Now, you have different quantum of amounts invested in each of these schemes.  But for you, all these 5 schemes with appropriate weight put together is your portfolio.  You want to have a consolidated view of stock and debt investments happened through these 5 schemes.  This portfolio scanner tool helps in getting information from across different schemes, collate the similar stocks and debt instruments and presents an overall view.

For example let us say there is a sample portfolio of Rs 1 Lakh each in HDFC Tax Saver and UTI Mid Cap Fund. Here is how the consolidated stocks stack up.




This is a snapshot of the sectors




And here, are the instruments in the Rs 2 Lakh portfolio (of 1 Lakh each in HDFC Tax Saver and UTI Mid Cap Fund)




And this view helps searching for a particular stock and how the total value in the stock is split up across the MF schemes invested in.



The online MF portfolio scanner is published here. You need to upload the portfolio of various MF schemes in an excel file (.xlsx). The excel sheet has to have a single sheet named "Portfolio" and have 3 columns to be populated as depicted in the below template.  The file name column is just an identifier for the MF and the application saves the portfolio of the scheme in the said name - it might save in the server, you will not be able to see that.

Loan Amortization

I see a few otherwise prudent people getting into housing loan and trapping themselves.  The story goes something like this. Often people see their friends and friends of friends purchasing houses in various cities and the talks in social connects involve how someone purchased a flat for Rs X near a new suburb and suddenly the price shot up to Rs 1.6X, often ending with some statement like, "If we think of buying a house at this point in time, I definitely cannot afford it.  It was so fortunate and with god's grace that I happened to purchase this house 5 years before"  And they want everyone to give them post-purchase approval and satisfaction.  They make statements like, "See how this area has developed.  Who would have thought this 5 star hotel and that huge mall would come here even a few years before".

Ok, now people who thought of saving and purchasing a house, they start to get tempted. And this story repeats itself in multiple occasions for the "saving" people to ignore it completely.  And that's when the "home-buying" bug hits them. "We need to get a house. Dot!"  But the outskirts areas in the cities are not affordable, so they settle something on outer-outskirts, the nearest to nearest district of the city they would want to work, consoling themselves, "These areas are the new bright spots, see how the place will look like a few years from now".  A few years from now moves on and the area remains the same.  The people who bought with that only hope are now in denial - how could they have made a wrong decision.  The problem is not every area will develop in the same pace and the development takes into account multiple factors - no one will be able to judge or predict.  For every owner who said their area got developed so fast in so less time, there will be 5 others who said the place is just as it existed 10 years before.

The problem is with the people who are buying houses not to live in but considering it as in investment.  House, especially an apartment is never an investment.  The rental yields are so low - around 2 to 2.5% and the building value actually depreciates over the years.  It may sound like an investment because of the development that happens around, in certain instances. They get into huge loans for the entitlement of "I own a house now!" and "It is a great investment",  "I do not want to miss the opportunity now".

By the way, until the loan is paid off, the house belongs to the bankers!  Now coming back to the topic: loan amortization.

Consider this scenario: An apartment costs 30 Lakh Rupees (3 Million Rupees) for which a loan of Rs 20 Lakh taken at 10% to be repaid over 20 years as an equated monthly instalments (EMIs) of Rs 19135. The borrowers really have no clue about how this amortization works. They keep paying this amount every month and even after 3 or 4 years, their outstanding amount hardly reduces.  And the weight of the loan sits real heavy on the shoulders!  In the initial years, most of what is paid as instalment go in paying of the interest and only a little goes and pays off the outstanding principal.

Given below are the loan amortization inputs.

See how the initial payment contributes only Rs 3k towards principal, gradually increases to contribute to the whole of the outstanding principal towards the finishing years of loan tenure.  And an inverse relation is observed with the interest which actualy keeps reducing from 15k to 0.

Now, if you look at how the balance repayment happens, it gives a very interesting perspective. Out of the 20 Lakh loan, it take about 9.5 years to pay the first 5 lakhs, 5 years to pay the second five lakhs.  Out of the total loan tenure of 20 years, almost initial 14 years goes in paying off only half of the dues! The third and fourth 5 lakhs take around 3.25 and 2.25 years respectively.

To put the same in terms of time period: if the 20 year period is divided into 4 year buckets, the balance repayment happening in the buckets are respectively 1.74, 2.3, 3.43, 5.11 and 7.42 Lakhs.  It needs a very strong heart to see that the the outstanding amount even after 12 years is around 12.5 Lakhs!

Overall payment of Rs 19135 * 240 = Rs 45.92 lakhs for a Rs 20 Lakh loan!

I have published this online loan EMI calculator.

Curious case of burnt currency notes!

It has been one week since the demonetisation drive by the Government.  500 and 1000 rupee notes ceased to become legal tender since 9th Nov 2016 00:00 hrs.  ATMs country-wide closed on 9th and 10th Nov - to facilitate banks and agencies to replace the 1000 and 500 rupee notes with 100 rupee notes. A new 2000 rupee note got introduced which are now available only in a few ATMs, as the ATMs are not designed to handle the new 2000 rupee notes. 9th Nov was declared as a non-working day for banks for them to prepare for the situation.

The objective behind the ban on 500 and 100 rupee notes as stated by our Prime Minister in his 8th Nov 8 pm speech is to tackle counterfeit notes likely to be let into the Indian economic system from Pakistan, to tackle the terrorism financing especially by the counterfeit notes and to put a check on the black money.

There have been several measures taken by the Government to help ease people's need for cash, and for exchanging the old notes.  The 500 and 1000 rupee notes continued to get exchanged at Airports, Railway stations, hospitals, petrol stations and utility payments till 14th Nov, which later extended to 24th Nov.  Tolls were queued up on 9th and 10th which were then asked not to collect tolls till 14th Nov, which now got extended to 18th Nov.

To limit people converting black to white, some restrictions are enforced.
1. A limit of Rs 4000 for exchange of old notes to new notes
2. A daily withdrawal limit of Rs 10000 and weekly withdrawal limit of Rs 20000 from banks.
3. A daily withdrawal limit of Rs 2000 from ATMs.
4. No limit on cash deposits (of course, people would need to answer if they deposited huge amount at one go)

From Monday 15th Nov, these limits are increased to 4500, no daily limit, 24000, 2500 respectively.

Government has not thought of all possible tricks that people may play to convert black to white but is very quick in plugging the holes.  For example, since the trains can be reserved in advance of 4 months, expensive tickets in high end trains like Rajdhani and Shatabdi started getting booked, with the objective that people can later cancel it and make it white.  GoI issued a notice saying that cancellation of tickets will be processed with cheque or online transfer only - and after scrutiny.  The amount will be credited only after a minimum of 30 days from the date of cancellation. Advance payments has increased in utility payments like Bescom, BBMP and similar city corporations.  GoI has issued notice to stop accepting all advance payments.

The ban on 500 and 1000 notes comes after the VDIS program where there is a no question asked 45% tax and you keep rest 55%.  Now, there is no such impunity from the Income Tax department.  For all unaccounted cash deposits, there is an income tax and a penalty of 200% followed by further investigation. By some calculation (not verified), one can retain only around 10% of unaccounted cash after all tax and penalties.  All cash deposits and credit card advance payments will get reported.  In practice, there has been a system of AIR (Annual Information Reporting) on some key areas like credit card payments, cash deposits, MF or Stocks purchase. More details here: https://www.tin-nsdl.com/air/anninforeturn.php


Because of this, a few people resort to burning the currency notes.  The people who burn cash may think: "Hello Government of India, you have created a situation where you will not allow me to keep my money.  Now, why should I come and give it to you.  I will burn it away, so you will not benefit from my cash!" May be the people have not read what is written on the currency note. "I promise to pay the bearer the sum of one thousand rupees", signed RBI Governor.

Let us try to understand it with a different story. Anand, Bala and Chitra are vendors in a shopping mall. Anand sells flowers, Bala sells sweets and Chitra sells beverages.  Generally they have a few transactions among themselves which they promptly pay at regular intervals.  One day, Anand buys some sweets from Bala and he does not have ready cash to pay.  So he gives a handwritten note to Bala "To whomsoever, I will pay you 100 Rupees - signed, Anand" and tells him to bring it back next day and get Rs 100. Bala agrees. Later Bala purchases some beverages for Rs 100 from Chitra and gives the note signed by Anand.  Chitra accepts that because she knows Anand has been giving such chits on his special paper and honours them the next day.  Towards evening, somehow Chitra accidently burnt the note given by Anand.  She cannot ask Bala, because the transaction with him is already over.  She cannot ask Anand, because he will honour only if he gets his note.

Similarly, the currency note is a promissory note.  RBI will treat them as a liability.  The 500 and 1000 notes are worthless after March2017.  RBI knows how many of 500 and 1000 notes it has issued and by March 2017 how many it has got back.  The remaining notes which are burnt, burried or washed away will cease to become its liability and RBI for sure can write back that amount.

So, anyone who burns the 500 Rs or 1000 Rs currency note is effectively transferring it to the coffers of RBI.

Now the question is: What happens if I burn a Rs 100 note?

Benford's law

I just happened to stumble upon the Wikipedia page of Benford's law  which states that
"In many naturally occurring collections of numbers, the leading significant digit is likely to be small" - To put in other words, when you gather some collection of numbers, the count of numbers that start with "1" are more compared to the count of numbers that start with "2" and so on.  In the wikipedia article, we see some examples such as the distribution of physical constants, the population of 237 countries which seem to obey the law.

Here we shall take a different data set and see how the numbers are thrown up. Taking Sachin Tendulkar's scores from cricinfo and modifying to have scores only from the matches where he scored - leaving out non-scoring or non-batting matches.

Here comes the distribution - Of all his scores, on the numbers in which these scores start with

firstDigit
 1   2   3   4   5   6   7   8   9
127  63  58  45  31  38  19  29  22

And in Percentage terms,

firstDigit
   1     2     3     4     5     6     7     8     9
29.40 14.58 13.43 10.42  7.18  8.80  4.40  6.71  5.09

which is in line with Benford's law!

The occurrence of each digit, using Benford's law is given with a probability
    p(d) = log(1 + 1/d), log to the base 10

 
As a different exercise, I want to see whether Benford's law is obeyed in other bases.

Converted the scores into octal numbers and re-configured the probability formula to take in multiple bases - and the law applies.

                                   

By the way, if you convert to binary number, there is only p(1) which is always 100% - Starting digit in a binary number is always 1!

Thoughts on Gold

I happened to have a look at the gold prices today.  It is almost the same as it was 5 years before. Take for example, HDFC Gold ETF. Current price is around Rs 2800 per gram.  The graph below (from www.valueresearchonline.com) shows the gold prices (in appreciation percentage) for the last five years - Nov 2011 to Nov 2016.

So, for someone who had invested exactly 5 years before, the current result is same as keeping the cash under the mattress.  Except for the roller-coaster ride which the gold investor experienced in the said period (only, if he were to watch the prices constantly).  The price went up to Rs 3160 per gram in Sep 2012 and dropped to Rs 2470 per gram in June 2013 and immediately in 2 months went up to Rs 3075 per gm in Aug 2013 and dropped to Rs 2350 per gram in December 2015. Now, back at Rs 2800 as it was in Nov 2011.

Five years is a sufficiently long time, and except for the volatility that gold offered, it has not generated any wealth. It seems as such there is no use in accumulating the metal.  The price is driven by consumption (majorly accumulation in the form of jewels), supply and demand.  The returns from gold is only through appreciation as it is not an income generating asset.  You buy with the only hope that it will appreciate.  People still consider it as an asset. At best, it can be considered as an illiquid cash (oxymoron!) Gold, for most people is an expensive ornament and serves no further.

Of course, the sample size (in this case, it is just one 5 year period), the period taken, can all be in contention.  But overall, gold prices can stay at par with inflation adjusted for currency exchange rates.  Not any more.

But, there have been business that thrive on gold - gold jewellers and gold loan companies.  For every gram sold in the form of jewelry, the owners make roughly 15% as making charges.  And if an ornament is bought, later melted and remade after a few years - the jewellers make additional making charges on the same gold sold.  It does not matter whether it is the same jeweller or different.  If you consider all jewellers as one group, you bought from the group and again gave back to them to be melted and remade a few years later, giving them double making charges on the same gold.

The gold loan companies on the other hand convert the "illiquid cash" to "liquid cash" at a price, charging huge interest rates, at the same time having a right on the gold which is pledged.  They take a margin of around 30% to account for volatility.  By the way, in the said period there have been only one instance where the price had gone down by around 25%.  Better off actually selling and buying back later, there by you pay an overall 15% extra making charges while buying again, instead of repeated interest payments at 20% while not having the right on the gold as well.