How the young should save and invest

Options are a double edge sword: having multiple alternatives is great, but having too many is confusing. As a young investor looking to park your hard-earned money, you will be spoilt for choice -- just as you are when you shop for anything else.

In the first part of this series, we discussed how young investors could start saving and how they should allocate their investments across different asset classes: equities, debt, commodities, real estate, infrastructure and others. We also talked about how investors should choose products based on the fund manager's profile, cost of investing, liquidity, tax efficiency and long term performance profile.

In the second part of the series, we look at specific investment solutions within two of the most important asset classes -- debt and equities -- and see how they fit into a young investor's plan.

Equities

Equities are the one of the most accessible options for a young investor with a wide range of product offerings. The three most suitable options for the young are:

Mutual fund

Equity mutual funds come in all ranges and sizes. The three most common being diversified funds, index funds and sector funds.

Diversified funds hold a large number of securities and try to beat the performance of an index (example: NIFTY, SENSEX), index funds try to replicate the performance of an index, and sector funds hold stocks in a specific sector (example: pharmaceuticals, IT).

Young investors should hold index funds because they have relatively low fees and provide a diversified portfolio of index stocks. Diversified funds are more expensive, while sector funds concentrate your risk in one particular sector. 

When choosing an index fund, choose one with a low expense ratio and no or little exit loads. If you are purchasing funds through a distributor, ensure you are not paying entry loads as per recent regulation. You may see funds with both growth and dividend options -- growth options provide returns through the growth in NAV (net asset value), dividend options pay out dividends at a specific frequency (weekly, monthly, etc.). Ensure you check the credentials of the fund management team and understand the holdings of the fund. If you are allocating an amount to your savings every month, consider a systematic investing plan (SIP).

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.

Portfolio management services provide you customised equity products to meet your investment needs. You will benefit from professional expertise, a sophisticated product, regular monitoring of your portfolio, and personalised service. The fee structure can be tailored to your needs to be fixed fee or variable fee-based. The only disadvantage is that PMS requires a higher minimum investment (Rs 5 lakh).

If you are a young investor with a larger corpus to invest, consider a good PMS offering by a strong manager as an alternative to mutual funds.

Exchange traded funds

Benchmark Asset Management offers NIFTY BeES, an exchange traded fund that tracks the NIFTY. It is a product ideally suited for young investors because it provides diversified equity exposure, has low expense ratios, no exit loads and gives you daily liquidity with your money. NIFTY BeES also enjoys the tax advantages of a mutual fund, and has done a better job tracking the NIFTY historically than any other index mutual fund.

You can purchase NIFTY BeES by opening a demat account with any depository and placing an order over the phone with your broker, as you would for any other stock. There are also other well known ETFs you can consider -- JUNIOR BeES offered by Benchmark, QNIFTY offered by Quantum, and SUNDER by UTI.

There are three other equity investment alternatives you may have heard of however these are less suited to young investors.

ULIPS

ULIPs combine insurance with equity investments, and should generally be avoided by everyone. Insurance is about protecting your assets and family in the long run, while equity investments are about growing your capital. These are two separate decisions and should not be combined in one investment. In addition, while entry loads have been prohibited in mutual funds, distributors still charge high entry loads for ULIPs. As an ULIP investor, you thus pay very high fees for something that is an unclear combination of insurance and a mutual fund.

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.

As we discussed in Part 1, many young investors are tempted to hold individual stocks and trade based on reports they have read or tips they have heard. This is unadvisable: investing sensibly requires professional judgment and regular monitoring of your portfolio. Picking a few stocks on your own leads to a portfolio that is un-diversified.

Trading stocks regularly on your own is also expensive and tax inefficient because you pay short-term capital gains tax on any gains made under a year.

Futures and options

You may have heard of equity futures and options products, popularly called F&O or derivative products. F&O investments are risky because you can lose more than you invest, and should not be considered by young investors. Gains from F&O investments are subject to personal income tax rates, which are often higher than short-term capital gains tax.

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.

Debt is a safe instrument and essential to every young investor's portfolio. The range of investment alternatives available to a young investor is:

Savings accounts

Retaining your money in a savings account provides you a safe way to earn interest while giving you liquid access to your funds.

Unfortunately the yields on savings accounts are very low (between 3 to 3.5 per cent) and interest is taxed at personal income tax rates. Keep only what you need to spend on a regular basis in a savings account.

Fixed deposits

Like a savings account, bank fixed deposits pay interest, with the difference being that your money is locked-in for a specific period (three-months, one year, etc.).   Usually, the longer the period of the deposit, the higher the yield you earn.

Yields on longer term fixed deposits are higher than savings accounts, but the interest is also taxed at personal income tax rates. Your money is locked-in for the term of the deposit -- if you withdraw it, you lose the interest and pay a penalty. Opt for a debt mutual fund instead of a fixed deposit -- it will provide higher after-tax yields with more liquidity and not much more risk.

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.

Debt mutual funds are the best alternative for young investors looking for debt exposure.

These funds invest in various debt products including safer government bonds and money market instruments as well as more risky corporate debt. They come in various tenures -- immediate term or cash management, short term, medium term and long term -- where the tenure indicates the maturity of bonds the fund holds.  The higher the tenure, typically, the higher the returns you earn and the higher the fees you pay.

Debt mutual funds are taxed at more favourable rates than fixed deposits, particularly if you opt for a dividend fund (rather than a growth fund). Dividend funds pay dividends at a pre-specified frequency and these are tax free in your hands.

Since interests rates today are their historical lows, choose a short-term fund a with three month horizon so that you do not lock in your capital. When rates pick up, you can invest in a medium or longer-term fund. Select a fund with low expense ratios and no exit loads so that you have regular access to your capital. Check the holdings of the fund and the experience of the fund manager -- ensure the fund is holding primarily government securities and corporate bonds of well-rated established firms.

Exchange traded liquid funds

Similar to NIFTY BeES, Benchmark provides LIQUID BeES, an exchange traded bond fund. LIQUID BeES are similar to a immediate term bond and are only suitable for investors who need daily access to their capital. For young investors, it is better to opt for short-term bond funds which provide a higher yield for a little less liquidity.

Company debentures, fixed deposits and bonds

Similar to government bonds and bank fixed deposits, these are bonds issued by companies (example: the recent L&T NCD debenture). While they have higher rates of interest than government bonds, young investors should avoid them. Do not concentrate your risk on one individual firm because you risk losing your capital if the firm defaults.

Long-term options from the Government of India

The Government of India provides many options including PPFs (public provident funds), which are opened with a PSU bank, small savings schemes of post office, and RBI bonds. The upside is that most of these products offer a fixed rate of interest and are backed by the Government of India. Unfortunately, these schemes lock in your capital for a long period, say, 15 years for PPF schemes, up to six years for post office schemes and typically six years for RBI bonds.

Young investors should consider these alternatives only if they want to safely lock-in capital for a long period of time. 

Getting started

There is no limit to the range of options available to you as a young investor. Do your research on both equities and debt, pick a few good investment alternatives, and start building your savings. Most importantly, ask your fund managers all the questions you have about how they are going to invest your money and what you will be charged for the service.

When it comes to your money, no question is a bad one.

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.